Save Your Company: Discovering Financial Fraud (Part 4 of 4)

During the Texas oil boom of the 1980s, I worked with a company to help get its finances in order. I walked into a financial meltdown, and in the course of my work, I uncovered a slew of management errors -- and even some full-on deceit and treachery -- that was bringing the company to ruin. This blogpost examines a critical lesson about financial management that came through my accounting work with this company.

The Problem: Embezzlement

We had established control over the flow of information that the accounting department needed to provide timely and accurate information with which to manage the company. Accounting was current and, after migrating to accounting software designed for our business model, we had reduced accounting staff from more than 30 to an effective team of less than 10. I am most proud of the fact that I took a large, demoralized group deemed incompetent by senior management and created a small, highly respected team that was proud of their accomplishments and of their ability to exceed management expectations.

With the operational aspects under control, I had more time to review accounting reports and look for the meaning behind the numbers. My mission was now to play detective, to identify financial data I couldn’t explain, and to find out what had transpired. That’s when I finally focused on a $250,000 deferred credit that had been bothering me. I asked the general ledger accountant what the entry represented and was told that, prior to my involvement with the company, the chief financial officer had told her how to record the sale of a minicomputer. The entire entry didn’t make sense.

Prior to the formation of our executive committee to manage payments to vendors, the CFO had possessed sole authority to make these decisions and used it to extract kickbacks from local, non-essential vendors to pay them ahead of vendors whose services were required for continued operations.

The CFO also later admitted to an unsuccessful attempt to burn down the company offices to prevent exposure of his embezzlement. Most fascinating was his motivation: He had been a partner in an exotic car dealership that had failed after borrowing money from loan sharks. His partner had been found murdered in the parking lot of a local mall, and our CFO was desperate to repay his debt lest he meet a similar fate.

The investigation ultimately led to the resignation of the CFO for embezzlement and arson.

The Lesson: Examine Comparative Financials

The failure to include field operations managers' input in decisions about paying vendors placed the company's continued operations in jeopardy. Even if the CFO had been acting in the best interests of the company, he didn't have sufficient information to make the best decisions about who to pay.

By giving the CFO sole unquestioned authority over the vendor payment process, the company exposed itself to unnecessary risk of fraud.

I uncovered embezzlement only because I wanted to assure the accounting validity and fully understand the state of the business. As a business owner or as a manager, you want to manage by exception. You don't have time to get bogged down in the minutiae, but you can look at the big picture and see if it makes sense.

One of the best tools to do this with is comparative financials, by month or by quarter. Look for period to period patterns. For example, certain expenses, such as rent or utilities, will be consistent over time. Other expenses, such as cost of goods sold, will correlate with sales revenue. Do you see changes that don’t fit the pattern you've come to expect? Focus on things that don’t make sense and find out why. 

There are only two possible results your investigation will yield. Either there's an accounting error or your perception of your business is incorrect. If the accounting doesn’t properly reflect your business operations, you can make proper corrections or adjustments to the books or your accounting procedures. If, however, the accounting does reflect your operation, you're now armed with information with which to make business course adjustments.