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Cardinal Wholesalers, Inc. Student Manual Page 1

CARDINAL WHOLESALERS, INC.© A FRAUD EXAMINATION/AUDITING CASE SIMULATION

By Thomas Buckhoff and Bonita Peterson Kramer © No part of this work may be reproduced or used in any form or by any means without the written permission of the authors.

CASE BACKGROUND1 Bill Carter

Bill Carter had invested the last 22 years of his life working for Cardinal Wholesalers,

Inc.—a Fortune 500 corporation that operated a grocery store chain with over 300 locations

nationwide. His job as a purchasing department manager paid him an annual salary of $60,000

per year, which was sufficient to support his wife and three children. Now he found himself

unemployed—fired, to be exact—and for what? Jill, who worked in Bill’s department, had

caught him looking at ‘inappropriate’ websites while he had some downtime at work. It was all

so unfair. Bill knew others within the company who had done the same thing and they weren’t

fired. Why? Because they had never been caught by someone willing to turn them in to

management. After receiving Jill’s formal complaint memo, management decided to send a

signal to the company’s rank and file that looking at inappropriate websites on company time

and using company equipment was unacceptable and would not be tolerated. So Bill was given a

pink slip, told to clear out his desk immediately, and received two weeks severance pay.

Ashamed to tell his wife and kids the real reason he lost his job, Bill told them he had

been laid off due to ‘corporate downsizing.’ Whatever the reason, he had to figure out a way to

support his family before his severance pay ran out. With only two weeks of severance pay, Bill

needed to find a new source of income right away or he wouldn’t be able to make payments on

the family’s debts, which included: a $1,980 per month mortgage payment, $900 per month in

car payments, minimum payments of $450 per month on outstanding credit card debt totaling

$38,000, and education expenses for his oldest child who was attending an expensive Ivy-league

university. Over the next few days Bill diligently searched the want ads, visited the local job

service, sent out resumes, and even had an appointment with the placement center at State

1 This case is based on an actual fraud investigated by one of the authors. The names of the victim organization and the various players involved have all been changed to protect their privacy.

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University, where he had obtained a bachelor’s degree in business administration about 25 years

ago. However, after a week of actively exploring the job market with no good leads and three

dead end interviews, Bill began to feel increasingly desperate about his financial situation,

which, in turn, increased his anger towards his former employer for making him a scapegoat and

putting him in this situation.

Mike Smith

Mike Smith formerly reported to Bill in the purchasing department of Cardinal. He and

Bill had developed a close friendship working together during the five years leading up to Bill’s

firing. Mike also felt strongly that management had treated Bill unfairly. Consequently, Mike

had mixed feelings when he was promoted to fill Bill’s former position as purchasing department

manager. He felt like a traitor to Bill for accepting the promotion. However, he could certainly

use the extra $15,000 per year in salary to help pay off some large debts he had accumulated

during the five years since his graduation from State University. Even though his $45,000 per

year salary was enough to provide comfortably for a single person, Mike had not done a very

good job of managing his personal finances. He leased a nice $1,500 per month condominium as

well as an $800 per month Audi. He had accumulated $15,000 in student loan debt and another

$25,000 in credit card debt, most of which was used to purchase furniture, a home theater system

with big-screen TV, and other home furnishings. On top of all this, Mike had foolishly amassed

more than $50,000 in gambling debts, on which he was obligated to make monthly payments.

Mike loved the night life and especially enjoyed the challenge and thrill associated with

gambling. Even though he voraciously consumed every book he could find on how to beat the

odds, somehow the house managed to get the best of him over the last five years. Mike

continuously believed that someday his luck would change and he would “hit the big one” and

pay off all his debts.

The Proposition

In his desperation to obtain a new source of income, Bill thought of an idea that could at

least temporarily provide him with some cash flow until he secured other employment. As the

former purchasing department manager of Cardinal he was familiar with the company’s system

of authorizing and processing cash disbursement requests. As purchasing department manager,

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he had the authority to place vendors on the approved vendor list, he could initiate purchase

orders for goods and services, and he approved payment on incoming vendor invoices. Bill

could create a shell company2 and send invoices to Cardinal as if some goods or services were

being provided, when in fact nothing was provided. This could provide him with a temporary

source of income until he got another job. All he needed for his plan to succeed was to get

someone within Cardinal to approve payment on the shell company invoices. That’s when he

thought of his old friend, Mike. Bill phoned Mike and invited him to have a drink at their

favorite sports bar after work the next day. Mike accepted.

After getting caught up on company gossip, Bill matter-of-factly presented Mike with a

proposition: Bill would create a shell company and generate bogus invoices, which would then

be submitted to Cardinal as if a service was being provided. Mike simply had to place the

vendor on the approved vendor list and then approve payment on the incoming bogus invoices.

Accounts payable would send the check to the vendor’s post office box address. Bill would then

retrieve the check, deposit it into a bank account opened in the shell company’s name, and they

would split the money fifty-fifty. Bill further explained that the scheme would not be detected

since Cardinal typically paid hundreds of millions of dollars annually to tens of thousands of

different vendors. No way would the auditors or anyone else notice a few thousand dollars paid

periodically to one bogus vendor. Moreover, Cardinal did not independently verify receipt of

services before paying vendor invoices. Creating a shell company simply required filling out a

one-page application and paying a $25 registration fee to the secretary of state, which would then

provide Bill with a ‘doing-business-as’ certificate. The certificate could then be used to open a

post office box and a bank account in the name of the shell company. All that Mike needed to

do was approve payment on the incoming bogus invoices. The scheme was fool proof. And

besides, both of them could use the extra money. Mike agreed to think about it and get back to

Bill within a week. After thinking it over for a few days, Mike decided that this was probably

the only way he could pay off his debts and make a fresh start. He could always back out of the

scheme after his debts were paid off. Mike called Bill back and accepted the proposition.

2 Shell companies are created for the sole purpose of committing fraud. They produce no goods or services; they are businesses on paper only.

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The Tip

The scheme worked so well that neither Bill nor Mike considered ending it after their

debts had been paid off. In fact, after five years they had each pocketed almost $1 million

dollars, tax free, from the scheme. Neither the auditors, nor anyone else, ever questioned any of

the payments being made to the shell company. Bill and Mike were both enjoying extremely

comfortable, even extravagant, lifestyles. Despite the fraudulent diversion of funds, Cardinal

was reporting above-average profits. Things couldn’t have been better; that is until too much

alcohol and a loose tongue resulted in their undoing. One evening Bill was visiting a local bar

and had a few too many drinks. Consequently, he began bragging about his fraud scheme to a

stranger sitting next to him in the bar. Bill told the stranger all of the relevant details of the

scheme: the name of the shell company, the name of the victim company (Cardinal), his own

name as well as the name of his inside accomplice, and how much they had stolen over the last

five years. The next morning (January 6) the stranger decided to cash in on this information and

called Cardinal, the victim company. Eventually the call was transferred to the office of the

chief loss prevention specialist, Debbie Roberts. The stranger informed Debbie that “a vendor

scheme is costing your company millions of dollars, and for $250,000 I will tell you which

vendor it is.” Debbie balked at paying the $250,000 and counter offered $20,000. The stranger

refused and the phone call ended. Debbie now knew that a fraudulent vendor existed amongst

the tens of thousands of vendors in Cardinal’s vendor database. The only problem was how to

figure out which one it was.

Required Assignments

1. After reviewing the background information above, write a 1-2 page memo evaluating

both Bill Carter and Mike Smith in terms of the fraud triangle.

2. Debbie Roberts, Cardinal’s chief loss prevention specialist, engages you, the aspiring

fraud examiner, to identify the fraudulent vendor. You accept the engagement. You first

must educate yourself about: (a) how vendor schemes3 work, (b) how they can be

detected [i.e. identify common red flags], (c) how they can be investigated, and (d) how

3 These schemes include and can also be called shell company schemes, fictitious vendor schemes, billing schemes, pass-through schemes, and/or false vendor schemes.

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they can be effectively prevented. The Primer on Fraud contained in the Appendix

provides background information you need to understand before proceeding to

Requirement 3. Once you have educated yourself on these topics, write a 2-3 page memo

explaining the four areas above. Submit the memo to your professor for grading and

continue to Requirement 3. Caveat: A thorough understanding of the material contained

in the Primer on Fraud is necessary to successfully complete the remainder of this case

simulation.

3. Your engagement task is to identify the fraudulent vendor in the vendor database

contained in the Cardinal Vendors Excel file provided on this CD. However, it would be

too tedious and time consuming to physically inspect the invoices of 1,000 vendors.

Accordingly, you decide to narrow the list of vendors by examining red flags that would

be evident in the vendor database. As a result, the computer can perform much of the

work. Using Excel’s AutoFilter function4, you decide to query three separate data fields

contained in the vendor database: Taxpayer ID, Address, and Phone #. After performing

the queries, rank the vendors by how many suspicious characteristics they possess. For

example, a vendor with either no taxpayer ID number or an invalid one would possess

one suspicious characteristic. Thus, your queries should result in four groups of vendors:

(1) those possessing three suspicious characteristics, (2) those possessing two suspicious

characteristics, (3) those possessing one suspicious characteristic, and (4) those

possessing no suspicious characteristics. When you are confident that you have

identified the six most suspicious vendors, explain and defend your answers in Memo

format and submit to your instructor for grading. Then, you may proceed to Requirement

4.

4. Generate a list of red flags likely to be present on fraudulent vendor invoices. Using the

beginning letter of each of the six suspicious vendor names (in alphabetical order) as the

password, open the “Vendor Invoices” File. Examine the invoices looking for suspicious

characteristics. Look for items on the invoice that compensate for suspicious items

identified in the query of the vendor database. For example, if a certain vendor was

4 For an explanation of how to use Excel’s AutoFilter function, see Strategic Finance, April 2005, pages 46-49.

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flagged for not having a phone number in the database but the invoice has a phone

number, then that lowers the level of suspicion with respect to that vendor. After

carefully examining all of the invoices, select the vendor with the most suspicious

characteristics. Explain and defend your answer in Memo format. Submit your answer to

your instructor for grading. Once your answer has been successfully submitted, you may

proceed to Requirement 5.

5. Vendor schemes can be subcategorized as either fictitious vendor or pass-through

schemes. With fictitious vendor schemes the victim company receives nothing from the

fictitious vendor except the bogus invoices. Thus, the fraud loss is determined by adding

up the total payments made to the vendor. A pass-through scheme is one in which the

fraudster sets up a shell company as an unnecessary intermediary between a legitimate

vendor and the victim company and makes an unauthorized profit on the transaction.

Accordingly, with a pass-through scheme the victim company is actually receiving

something in exchange for payments made to the shell company. Thus, the fraud loss is

the amount of the unauthorized profit made by the fraudster. With pass-through schemes

the victim company receives invoices from the shell company instead of from the vendor

that is actually providing the products or services listed on the invoices. Based on your

understanding of how the two schemes work, develop a strategy for determining whether

the fraudster is perpetrating a fictitious vendor scheme or a pass-through scheme. Using

the most suspicious vendor’s taxpayer id number as the password, carefully examine the

“Bank Statement” file which contains the bank statement and copies of the cancelled

checks. Determine whether the suspicious vendor you have identified is a fictitious

vendor scheme or a pass-through scheme. Explain and defend your answer in Memo

format and submit it to your instructor for grading. Note: if the most suspicious vendor

does not have a taxpayer id number, type “blank” as the password. You may now

continue to Requirement 6.

6. Open the file ‘Summary’, which contains a spreadsheet summarizing all of the check

disbursements made payable to the suspicious vendor. The password for this file is also

the suspicious vendor’s taxpayer id number. Prepare a professional Memo to the client,

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Debbie Roberts, summarizing the evidence and estimating the fraud loss suffered as a

result of the fraud scheme you uncovered. Include some specific recommendations to

Cardinal for preventing this type of fraud in the future. Since you are billing the client

$10,000 for consulting services rendered, make sure the memo follows the basic

guidelines for writing professional memos. The professional quality of your memo, or

lack thereof, will significantly impact your grade. Submit your memo to your instructor

for grading.

Congratulations! You have just completed all of the tasks that were required in

conducting the actual fraud investigation. The Epilogue on this case is as follows:

Epilogue

The investigative report prepared by the certified fraud examiners was turned over to the

FBI along with the documentary evidence collected (e.g. fraudulent invoices, cancelled checks,

and spreadsheet exhibits). The FBI successfully charged and convicted both Mike Smith and

Bill Carter for mail fraud, which is the fraud statute most commonly used to prosecute fraud

cases. Bill Carter was sentenced to 54 months in prison and required to relinquish a $300,000

401K plan to Cardinal as restitution. In return for his guilty plea and testimony against Bill

Carter, Mike Smith received a lesser sentence of 48 months in prison. Finally, the certified fraud

examiners filed an employee dishonesty insurance claim on behalf of Cardinal with its insurance

provider. The insurance provider restituted Cardinal for its maximum coverage amount, $1

million, less a $25,000 deductible. Cardinal then engaged the certified fraud examiners to

provide anti-fraud training to all of its internal auditors and loss prevention specialists.

© No part of this work may be reproduced or used in any form or by any means without the written permission of the authors.

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APPENDIX: PRIMER ON FRAUD THE FRAUD TRIANGLE

To effectively detect and prevent fraud, we must first understand what motivates people

to commit fraud. Three essential elements are common to all types of fraud schemes:

opportunity, pressure, and rationalization. In combination, these three elements make up what is

commonly referred to as the “fraud triangle.”

The first and most critical element of the fraud triangle is perceived opportunity.

Fraudsters typically exploit their employment responsibilities as the means to defraud their

employers. Unfortunately, many organizations unwittingly and unwisely provide their employees

with a variety of opportunities to commit fraud. The most common opportunity-providing factor

is the lack of adequate controls for monitoring employee behavior. For example, a bookkeeper

for a large company was given the responsibility to prepare checks, sign the checks, and record

the payments in the cash disbursements journal. Not surprisingly, the bookkeeper soon

discovered an easy opportunity and embezzled about $1,000,000 of the company’s cash.

Adequate internal controls require–at the very least–that these three responsibilities be

segregated among at least two or more employees. Clearly, employees possessing such

“incompatible responsibilities” have been provided with an easy opportunity to commit fraud.

They can simply make out the checks (to themselves or to pay their own bills), sign the checks,

and then “hide” the fraud by charging it to a variety of expense accounts.

Not all employees will exploit opportunities to commit fraud. What is it that induces one

employee to commit fraud and the other to remain honest? Pressure is the second element of the

fraud triangle. Financial pressure can come from a variety of sources including:

� Lifestyle–the perceived need to maintain a high standard of living

� Personal debt–from credit cards, gambling losses, sexual addictions, drugs, alcohol, or

poor investments

� Business losses–caused by inflation, high interest rates, poor economy, or lack of

demand.

Employees burdened with financial pressure are desperately searching for ways to relieve that

pressure. Consequently, they should not be put in a position that would provide them with an

opportunity to commit fraud. Doing so would be analogous to employing an alcoholic as a

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bartender–an unwise decision with predictable results.

The third and final element of the fraud triangle is rationalization, which means that the

fraudster must somehow psychologically justify the fraud as something less than a crime.

Common rationalizations include:

� “They owe it to me. I deserve to get paid more.”

� “I’m only borrowing the money. I’ll pay it back.”

� “Nobody will miss it. The company can afford it.”

� “Everyone does it. I’m not hurting anyone.”

Those with low integrity generally have little trouble coming up with rationalizations for

defrauding their employers. Since many people in our society have placed themselves under

enormous financial pressure and have low integrity–the only thing they need to commit fraud is

opportunity. Based on our experience as fraud examiners, where there is opportunity we usually

find fraud. Consider the following case example:

The Fraud Triangle: A Case Example Victim organization: A medium-sized construction company

Fraudster: A longtime project manager and close personal friend of the owner

Fraud loss: $165,000 over two years

Opportunity: Lack of adequate internal controls

Pressures: Addition to home, medical bills, daughter in college, and extramarital affair

Rationalizations: “I intended to provide a real product to my employer” and “The owner is rich

and can afford it.”

Description of fraud scheme: As a project manager, “Steve” was in a position to select

suppliers, place orders, and then authorize payment to those suppliers. He then created two

“shell” companies to perpetrate a fictitious vendor scheme against his employer. Steve simply

sent invoices from the shell companies to his employer for supplies provided to projects he

supervised. Since receipt of supplies was not independently verified, Steve only had to approve

payment on the invoices and the checks were mailed to a post office box he had set up for both

vendors. As the fraud examiners in this case, we turned over the incriminating evidence to local

law enforcement and Steve was prosecuted and convicted of “theft by deception” and sentenced

to 12 months ‘imprisonment’ via electronic monitoring. We also filed an employee dishonesty

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insurance claim on behalf of the client and recovered the $165,000 fraud loss plus our fees from

the insurance provider.

People rarely commit fraud thinking they will be caught. The purpose of internal

controls is to safeguard assets and records, minimize opportunities to commit fraud, and monitor

employee behavior. Properly designed internal controls effectively instill in the minds of

employees the perception that fraudulent activity will be detected. This ‘perception of detection’

can be very effective in preventing fraud in the workplace. In today’s society of financial

pressure and low integrity, organizations without adequate fraud prevention programs will

continue to suffer substantial fraud losses and most will not even realize it.

Fraudsters prefer Cash

For obvious reasons, cash5 is the asset most often stolen by dishonest employees. In fact,

fraud research indicates that about 93% of all asset-theft fraud schemes involve cash with median

losses of $98,000 per incident (ACFE, 2004). If controls over cash receipts are weak, dishonest

employees will steal cash receipts via such schemes as skimming. If controls over cash

disbursements are weak, dishonest employees will steal cash disbursements via a number of

disbursement schemes. On-book fraud schemes occur after the item being stolen (e.g. cash or

inventory) has been recorded by the victim company’s accounting system. Such schemes can

usually be detected by examining the books and underlying source documents of the victim

company. Off-book fraud schemes occur before the item being stolen has been recorded by the

victim company’s accounting system. Off-book fraud schemes must be detected by using

indirect investigative methods such as financial statement analysis, surveillances, invigilations6,

and forensic interviews and interrogations.

5 Cash includes any medium of exchange that a bank will accept at face value, including currency and coins, company checks, customers’ personal checks, cashier’s checks, money orders, and/or bank drafts. It is not difficult for experienced fraudsters to convert checks to cash. 6 An invigilation is an investigative method whereby the internal controls over cash are made so strict that opportunities for fraud are eliminated and a fraud free profile can be established. For example, assume a business owner suspects her office manager of embezzling incoming cash receipts. The owner takes over all responsibilities for receiving, recording, and depositing incoming cash receipts for a period of time. If the office manager has been stealing, cash flows should inexplicably increase during the invigilation period.

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When conducting fraud examinations, we must first gain an understanding of the controls

and/or procedures in place for processing and recording cash flowing through a business. If

controls over incoming cash receipts are inadequate and those incoming cash flows are

substantial, then dishonest employees will attempt to divert some of that cash flow into their own

pockets. If controls over outgoing cash disbursements are inadequate, then dishonest employees

will attempt to divert some of those cash disbursements into their own pockets. A thorough

understanding of the controls over cash flows allows examiners to generate ideas concerning

how someone could steal cash from the organization and not get caught. These ideas, called

fraud theories, can be categorized as either off-book or on-book fraud schemes.

Off-Book Fraud Schemes

Skimming, a common off-book fraud scheme, involves the theft of incoming cash before

its entry into the accounting records. Skimming occurs when an employee sells goods or

services to a customer, collects the customer’s payment, but makes no record of the sale. For

example, the servers and bartenders at a local gentlemen’s club pocketed customers’ payments

for drinks and food, thereby cheating the business out of $871,000 in revenues. Such schemes

are called “off-book” frauds since no record of the fraud exists on the victim company’s books.

In these cases, the victim company typically does not know that a theft has occurred. Off-book

frauds cannot be detected by examining the books and records of the company and generally

occur at the point where cash enters the business. Accordingly, those responsible for receiving,

processing, and/or recording cash are the likely perpetrators.

On-Book Fraud Schemes

Cash larceny, an on-book fraud scheme, involves the theft of cash after it has appeared

on the victim company’s books. For example, a teller stole $15,000 from the night vault at the

bank where she worked. Such schemes are called “on-book” frauds since an examination of the

victim company’s records could easily reveal the cash shortage. In these cases, the victim

company typically knows that a theft has occurred. On-book frauds can usually be detected by a

thorough examination of the books and underlying source documents of the company and can be

categorized as follows:

� Billing schemes

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� Payroll schemes

� Expense reimbursement schemes

� Check tampering schemes

� Register disbursement schemes

General Approach to Conducting a Fraud Examination

Since 93% of frauds involve cash, the proper sequence of events which should be

followed in a typical fraud examination include:

1. Develop a thorough understanding of the controls and/or procedures in place for

monitoring cash flowing through a business.

2. Generate fraud theories based on existing controls for monitoring cash flows (i.e.

brainstorm ideas regarding how someone could steal cash and not get caught).

3. Collect and evaluate evidence for testing the fraud theories.

4. Estimate losses being incurred from the fraud schemes uncovered.

5. Assist in filing employee dishonesty insurance claims, criminal, and/or civil charges.

6. Make recommendations for preventing future fraudulent activity.

Preventing Theft of Cash Disbursements

The most effective way to prevent theft of cash disbursements is to segregate the duties

of preparing checks and signing checks. Before preparing checks to pay vendor invoices, the

preparer should verify that the items listed on the vendor invoice were both ordered and received.

Copies of purchase orders and receiving documents should be made and forwarded to the person

responsible for preparing checks. Before signing, the check signer should: (1) review carefully

all information on the check along with the supporting documentation, (2) mark supporting

documentation as “paid” along with the date and check number, and (3) control the mailing of

the check (i.e., do not return a signed check to the person who prepared it). Finally, a third

person should review all cancelled checks for anomalies and perform monthly bank

reconciliations. Billing schemes involving vendors are possible due to one or more of the

following internal control deficiencies:

� Victim company does not verify the receipt of items/services before paying vendor

invoices (i.e., receiving reports were not prepared).

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� Disbursement checks are signed without adequate supporting documentation (i.e.,

purchase orders are not matched to vendor invoices and receiving reports).

� One employee can both place vendors on the approved vendor list and approve payment

on incoming vendor invoices.

� Cancelled checks are not reviewed for endorsement anomalies (i.e., the backs of the

checks bear handwritten or typewritten endorsements, instead of the usual stamped

endorsement.)

Adhering to basic controls over cash disbursements could have easily prevented Bill and Mike’s

fraud. Organizations without organized systems for safeguarding cash become breeding grounds

for fraudulent activity.

Vendor Schemes

In fictitious vendor schemes, the fraudster establishes a shell company that does not exist

and therefore, provides no goods or services to the victim organization. The shell company

periodically submits invoices to the victim organization, which then pays for the services or

goods never received. Thus, this scheme is possible when the fraudster can place the shell

company on the victim organization’s approved vendor list, either through poor internal controls

(e.g., no credit checks performed on new vendors), an inside accomplice, or both. The scheme is

further facilitated by the victim organization’s failure to independently verify receipt of

goods/services before paying incoming vendor invoices.

Since the check from the victim organization will be made payable to the name of the

shell company, the fraudster must establish a bank account in the shell company’s name.

However, banks typically require a “doing business as” (DBA) certificate in order to open the

account in the vendor’s name. DBA certificates can be easily obtained from the Office of the

Secretary of State by completing an application form and paying a nominal fee. The document

could possibly be forged, but it is more likely that the fraudster will simply obtain the legitimate

document from the government.

Because the shell company is not a legitimate business, it typically has no employees, no

physical location, no physical address, no phone number, etc. Therefore, the perpetrator will

often rent a post office box and use that as the shell company’s mailing address, although the

fraudster sometimes uses his/her own personal address or that of an accomplice.

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The bogus invoices can be easily generated from a personal computer. For example, an

Excel spreadsheet can produce a very professional-looking invoice simply by clicking on “New”

and then the invoice icon under “Spreadsheet Solutions”. However, typewritten or even

handwritten invoices have also been used to generate fraudulent disbursements.

The key to a successful fictitious vendor scheme is getting the victim organization to pay

the bogus invoices. The fraudster must be in a position to get the bogus invoices approved for

payment. This task can be quite easy if the victim company does not adequately segregate job

responsibilities. Other organizations may simply pay invoices based on an informal “check

request” that lists the name of the vendor, the amount owed, and a brief explanation. This, too,

makes perpetration of the fraud quite simple. Even if an organization has sound internal

controls, the perpetrator with approval authority can still successfully commit this fraud by

forging the necessary supporting documents (e.g., a purchase order and receiving report) and

signatures on these documents. This scheme can also be committed by a fraudster without

approval authority if the individual with that authority pays no attention to the invoices awaiting

approval and simply “rubber stamps” them. Of course, it is also possible for dishonest

employees to circumvent the internal controls by colluding or working together to perpetrate this

scheme. However, about 70% of fraud schemes are perpetrated by one person acting alone, only

30% involve collusion. Thus, the risk of fraud can be greatly reduced by simply involving at

least one other person in the transaction. The risk and opportunity for fraud cannot ever be

completely eliminated. The best we can do is to cost-effectively manage that risk to acceptable

levels by making the fraud as difficult to commit as possible.

Once the check has been prepared and signed, it is mailed to the shell company’s address,

which typically is a post office box opened by the fraudster in the name of the shell company.

The fraudster then retrieves the check, endorses and deposits it into a bank account opened in the

name of the shell company. At this point, the fraudster has unrestricted access to the funds and

can spend it however s/he pleases. Red flags common to fictitious vendor schemes include:

� Vendors without a taxpayer identification number or with an invalid one. A valid

taxpayer ID number has nine digits with the first two digits separated by a hyphen, as

follows: 12-3456789.

� Vendors listing a post office box address and no physical address. Also, vendor

addresses that match employee addresses.

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� Vendors with no phone number or those using an answering service.

� Invoices created using an Excel- or Word-generated invoice template.

� Invoices with fold mark anomalies. Examples: (1) invoices without fold marks or

creases, indicating they haven’t been mailed or (2) invoices with fold marks different

than the tri-fold indentations typical of invoices coming through the mail.

� Invoices with even dollar amounts, no taxes included, or other irregularities.

� Invoices from the same vendor that are consecutively numbered, indicating the vendor

has no other customers.

� Vendor-related cancelled checks that bear handwritten endorsements on the back.

� Invoices for unspecified consulting or other vaguely defined services.

� Vendors with company names consisting only of initials. Fraudsters often use their own

initials when setting up dummy companies (e.g., I. B. Crook establishes a fictitious

company named “IBC Enterprises”).

A fictitious vendor can often be detected by querying the vendor database for common

red flags that would be contained therein (e.g., no phone number, a post office box for an

address, invalid taxpayer ID number, an address that is identical to an employee’s address).

Such a query can be conducted easily using either Excel or data mining software such as ACL

(see www.acl.com). Since it is possible a legitimate vendor may exhibit one or more red flags,

the examiner next must review actual paper invoices from the narrowed list of suspicious

vendors. While reviewing the invoices, the examiner should look for red flags evident on the

actual paper invoices (e.g., invoices created using Excel, invoices with fold mark anomalies,

sequentially numbered invoices, etc.). Once the list of suspicious vendors has been narrowed

further, the examiner should examine the fictitious vendors’ bank statements along with

cancelled checks. A legitimate business would have cancelled checks for business-related

purchases. Since a fictitious vendor is only in the business of defrauding the victim organization,

its cancelled checks would be for personal purchases by the perpetrator.

To effectively prevent a fictitious vendor scheme from occurring, the victim organization

needs to implement a strong system of internal controls over its cash disbursements process.

Ideally, the duties of preparing vouchers and approving vouchers for payment should be

segregated. Properly approved purchase orders and receiving reports should be required to

support each invoice. The invoice details should be matched to the information on the purchase

Buckhoff & Kramer

Cardinal Wholesalers, Inc. Student Manual Page 16

order and receiving report. Authority to add new vendors to the approved vendor list should be

restricted to a specific individual. Background checks should be performed on new vendors

prior to adding them to the vendor list. For example, a credit check on a fictitious vendor would

reveal the company had no history, or a quick look in the phone book would reveal the company

had no phone service. Even a strong system of internal control cannot always prevent or detect

fraud if collusion is present, so to mitigate the risk of this occurring, the company’s auditors

should periodically review the approved vendor list, looking for red flags.

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