Internal Auditor Magazine - April 2009 - Whirlwind Of Deception

edited by andi mcneal

R One CFO, presented with pressure and opportunity, involves himself and others in a financial statement fraud that bankrupts a company. By J ay da w dy

FRAU D FIN D IN GS

Whirlwind of Deception obert Douglas, the chief finan­ cial officer (CFO) of Wind Power Systems (WPS), was very worried. A meticulous

accountant, Douglas had built a long and respected career as a financial executive. Now he was breaking every rule in the book, and he feared that a reckoning was imminent. When Douglas joined WPS less than five years ago, he thought it was the perfect job. As a fast-growing, publicly traded wind turbine manufacturer, WPS offered Doug­ las an opportunity to make a large amount of money in salary, incentives, and stock options. But two years ago, as financial pres­ sures mounted and sales failed to material­ ize, Douglas started manipulating the books so WPS could keep reaching its earnings esti­ mates. His scheme started small but quickly mushroomed into a significant financial statement fraud. Douglas told himself that the company would take off soon — sell and earn its way out of trouble — and then he would correct all of the accounting deceit. He realized that his time ran out one morn­ ing when he arrived at work early to find a trio of delivery trucks from Dillon’s, one of WPS’ vendors, blocking the entrances to the company’s parking lot. Douglas wasn’t the only one who noticed the delivery trucks that morning. Brenda Zimmer, a newly hired internal auditor, also arrived at work early and saw the con­ frontation that ensued. Despite Douglas’ pleading and apologies, Buster Dillon, the owner of Dillon’s, said he wasn’t moving his trucks until he received payment on very old invoices. A crowd of curious WPS employ­ ees was quickly forming, so Douglas hastily cut Dillon a check and told everyone it was a simple mix-up. But Zimmer’s skepticism grew. She had overheard the argument between Douglas and Dillon, and it didn’t sound like a misunderstanding to her. Zimmer wondered if WPS could be that tight on cash or if the company was simply

so disorganized that Dillon’s invoices had fallen through the cracks. She decided that neither answer was good for WPS. It was a bad sign when a company stopped paying one of its primary vendors, so Zimmer put on her investigative hat and went to work. By talking with accounts payable person­ nel at WPS, Zimmer discovered that payment delays and cash flow issues were widespread. Two accounts payable clerks stated that they had been instructed specifically by Douglas on numerous occasions to delay payments to vendors. Additionally, they confirmed that cash was very tight, which seemed to belie the company’s recent record earnings — unless WPS wasn’t collecting all of the money from those sales. Zimmer also interviewed an accounts receivable analyst, Jenny Clarkson. Dur­ ing the interview, Clarkson was obviously stressed. She said she had been trying to collect old receivables for the past few years, and the problem was getting worse. Customer complaints had gone up signifi­ cantly in the past year. They ranged from under-filled shipments, shipments received that had never been ordered, and promised discounts that were never applied. Because of such problems, many of the customers simply refused to pay their bills. Clarkson had investigated many of these complaints herself and found they were accurate. How­ ever, when she brought her concerns to her supervisor, Clarkson was told not to worry about it and to just do the best she could to collect the receivables. Clarkson also recom­ mended that several uncollectible accounts be written off, but was told that Douglas would never approve write-offs that would decrease earnings. Zimmer realized she was dealing with significant accounting issues. The earnings increases that WPS had been reporting didn’t match the incoming cash flow. And many receivables appeared to be bogus or april 2009 Internal Auditor

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F RAUD F I ND I N G S problematic — either due to mistakes or something more dishonest. After the initial interviews, Zimmer reviewed the company’s financial state­ ments closely and noticed that WPS had not written off any receivables in the past few years, despite having significant uncollect­ ible accounts. She wondered if some of the related sales were falsified and sought to con­ firm her suspicions by putting her forensic accounting skills to work. She started with a review of customer files and found that, in many cases, there were no signed contracts or purchase orders on file for shipments. She also found discrepancies in the quantities of product ordered and the amounts shipped and billed. In some cases, WPS shipped more product than was ordered and billed for the full shipment. In other cases, the amounts billed exceeded the number of items shipped. Both scenarios resulted in bogus sales, which, as Clarkson indicated, led to customer com­ plaints and refusals to pay. Zimmer also discovered huge increases in items shipped at the end of each quar­ ter, often propelling the company to sales and earnings figures that slightly exceeded analysts’ forecasts. Meeting these targets

had earned WPS praise on Wall Street and contributed to a soaring stock price. However, when she examined records from the subsequent periods, Zimmer saw a disproportionate number of returns at the beginning of each quarter and realized WPS had been channel stuffing to meet quarterly results. The only questions now were how bad the damage was and how high up the chain the fraud extended — who knew what when? As Zimmer attempted to interview high-level accounting and finance person­ nel, she was met with resistance and delays. She suspected Douglas was hindering her investigation by telling employees not to speak with her. Zimmer then discovered that WPS’ long-time controller, Stewart James, had left the company a few months before. She figured that a former employee like James might be more willing to discuss the accounting issues at WPS — and she was right. James explained in detail much of the story that Zimmer had suspected. He told Zimmer that he left WPS because he didn’t want to be a part of management’s account­ ing charade. In addition to confirming the

bogus shipments, channel stuffing, and over­ stated sales and receivables, James said WPS was “capitalizing everything under the sun.” James also shared that WPS had not written off obsolete inventory in several years. Every time he had brought up the bad receivables and inventory write-offs, Douglas told him to forget about it. James confirmed the involvement of senior management in the fraud and produced e-mails and other docu­ mentation to back up his story. Douglas finally cooperated when con­ fronted with the overwhelming evidence. He outlined exactly what had occurred at WPS over the past few years: Under pressure from the chief executive officer (CEO), Douglas, along with a group of sales, manufacturing, and shipping exec­ utives, had engaged in several accounting improprieties to meet earnings expecta­ tions and keep the company’s stock price high. Douglas said he had planned to correct the bogus accounting, but he was ordered to make the numbers work, and the accounting problems multiplied. After completing her investigation, Zim­ mer determined that the fraud had been ongoing for at least the past two years and

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F RAUD F I ND I N G S had grown considerably in scope in the past year as earnings pressures mounted. WPS had to restate two years’ worth of financial statements, triggering U.S. Department of Justice and Securities and Exchange Com­ mission investigations as well as shareholder lawsuits. As a result of the investigation and the restatements, Douglas, the CEO, and executives in both sales and manufacturing were terminated by the company. Several of the officers were indicted and prosecuted for their involvement in the fraud, includ­ ing Douglas and the CEO. The share price of WPS plummeted, and shortly thereafter the company declared bankruptcy. Le ssons Learned n A

single red flag, explored more fully, can lead to the discovery of much bigger issues. An inquiry into delayed vendor payments resulted in the detection of a massive account­ ing fraud. Internal auditors, external auditors, and investigators must pay attention to all red flags and investi­ gate accordingly. n A stronger internal audit function may have led to the discovery of WPS’

problems much earlier. The company’s internal audit function was weak for many years, and Zimmer was only hired due to pressure from the outside auditors to improve the internal audit function. Although the U.S. SarbanesOxley Act of 2002 has strengthened internal audit functions and increased audit committees’ responsibility and independence, these functions must have the appropriate authority and funding to be effective within any company. The members of both func­ tions must have the courage to step forward, investigate, and take action when they see management is on the wrong track. n A fraud hotline would have allowed James and Clarkson to blow the whistle, triggering an investiga­ tion. Had an anonymous reporting mechanism been in place, employees who had knowledge of the financial manipulations could have reported the scheme without fear of recrimina­ tion or retaliation. n Tone at the top is very important. If company executives don’t incorporate

a culture of ethics, an environment will exist where fraud can flourish. At WPS, the tone at the top was clearly lacking. The CEO aggressively pushed earnings targets, and other members of man­ agement resorted to financial manipu­ lation to meet these goals. Studies have shown that when senior management is involved in financial statement fraud, the fraud tends to go on longer and be more significant. This was certainly the case at WPS, and the company suf­ fered disastrous consequences. Jay Dawdy, CFE, CMA, is partner and senior managing director for Gryphon Investigations in White Plains, N.Y. To comment on this article, e-mail the author at [email protected]. WANTED: Your fraud finding stories. If you have a fraud finding you’d like to share, send it to: Andi McNeal, CFE, CPA ACFE World Headquarters E-mail: [email protected] Fax: +1-512-478-1444

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