The Slippery Slope to Fraud
from March/April 2003
As the old saying has it, the road to hell is paved with good intentions. The path to cooked books can start in just the same way. Sure, a handful of companies may have outright crooks high on the payroll. But “very rarely do you find a situation where a company has set out to be a sham, to create willful fraud,” says attorney Jerry C. Jones, a member of a panel put together by Wilson Sonsini Goodrich & Rosati. Jones spent 17 years defending outfits accused of accounting irregularities and now heads the legal team at Acxiom Corp., a data-storage company. Instead, he says, trouble may start with a management that decides to muscle its way through a crisis—one of several innocuous-seeming signs of danger that directors should watch out for.
The first question that’s usually asked when senior management realizes it has a problem is “How did we get into this situation? We’ve always been ethical.” So you need to be sensitized to the situations that come up in the life of any company in which fraud can grow. It’s usually cheating at the margin, and there’s usually some type of underlying business problem that drives people to go out and do things they otherwise wouldn’t do.
What you look for are things like, Is our product less competitive with others on the market? Is it getting a little bit long in the tooth, which makes it a little bit more difficult to sell? Those are situations that are ripe for some kind of abuse. Often we’ll see fraud develop out of increasingly competitive markets. A new competitor has come in, he is underpricing you, offering other throw-ins. Your sales force is having difficulty closing.
I’ve also seen cases where there’s a new paradigm in the market. For example, when the Internet first came in, companies were coming up with Internet deployment vehicles to get their product out. That is another situation that’s risky. Companies always think they are going to be able to implement correctly if they throw enough dollars at it.
What this suggests to me is that there are inflection points in the life of a company. You need to be sensitive to them and identify them. Aging products, a very competitive environment, a new paradigm in the market—all of these create business issues in which fraud can grow.
Couple that with management’s fixation on Wall Street growth targets and you get into real problems. Most companies are not willing to admit that the growth cycle is not always going to be 40% year over year, or 20% year over year. It might be 20% one year, and then there’s a product transition and growth might be 10% for a quarter or two. You need to be aware of that. It’s not straight-line growth. It’s much more like the way children grow up—in spurts.
Management, faced with these situations, will often take the traditional approach of “Well, let’s just muscle through this crisis. If we put more people on it, if we throw more resources at it, if we put more sales incentives out there, we will push through this current obstacle.” That approach may work, and it may work a couple of times, but it is a situation that often leads to fraud. People are failing to acknowledge that current quotas, current goals, are not realistic.
That gets you to the early stages of cheating. It’s not even accounting fraud at this point. For example, your sales force has to get a lot more aggressive. So what do they do? They give discounts to customers to take product early, creating a pattern of reaching forward. They start selling to less creditworthy customers and adding freebies, book-ins, extra training, other things like that. These cut into your margins a little bit.
At the end of a quarter, the finance people sit down trying to close the books, and the revenues are there but earnings are a little bit light. So what happens? You start to see self-serving rationalizations come up about accounts receivable. Reserves are subject to judgment, and the judgment becomes a little bit tougher and people aren’t willing to admit that there is a little cushion in there. You see it in reserves for accounts receivable, or, depending on your business, you may see it in reserves for excess and obsolete inventory. The point is, you know where the judgments are applied in your business, and you know where there’s a little bit of room at the end of the quarter.
Now this is a company that has set the stage for fraud, because it has reached forward and just made the prior quarter through a bunch of these sales techniques and creative judgments. Of course, it has not adjusted expectations on Wall Street, because it made its growth target. The company just keeps that growth target at, let’s say, 30% quarter over quarter. And managers have done the classic thing that usually happens before we see an accounting fraud—they have drained the pipeline going forward. All the sales prospects have been mined, all the freebies have been thrown out there, and there isn’t a whole lot left.
So let’s talk about early-stage fraud and how you catch it. What types of things do you look for? Last-minute contracts with people you don’t know: Why did the deal I was looking at in my pipeline chart shift from the company I knew to this other reseller we’ve never done business with before? You see a deal that was going to be sold direct to somebody, and suddenly a reseller has gotten involved and agreed to take it. All of these are suggestions that there may be something funny going on.
Another thing that we see a lot: There’s been a difficult negotiation, and then at the end of the quarter, like magic, the other side suddenly caves in. Now you want to be a little skeptical of that. In the normal course of business, people don’t just give up on a whole bunch of stuff they’ve been fighting about at the end of your quarter.
Something else worth mentioning is that you know how your customers order your products. Is the product mix that’s being ordered consistent with what these people normally order? Are they asking for something they normally don’t ask for, are we selling it to them in a way we don’t normally sell it? Did a contract come in 10 days after the end of the quarter, signed as of the last day of the quarter? You might want to look into that.
Now let’s assume that undetected fraud has been festering. How are you going to find it? The answer here is really simple: Follow the money. And that translates into, Are you collecting your receivables? And you know, if you look at a company that’s had a problem and you pull the list of receivables right before the fraud was discovered, you will find all of the flaky deals on that list, showing the money is uncollected. Sometimes you’ll see the company getting a little clever about returns and rotations, because if a customer returns a product or rotates it, that’s not a collection anymore. It’s become a new deal.
But you’re going to see it because, bottom line, this deal isn’t getting paid. There may be a customer issue, but more often than not someone has created some kind of a side arrangement or some other deal, trying to force product into the pipeline too soon.
The other thing to look at is contracts that get amended afterward. If it’s very sophisticated, you’ll see something like a reciprocal deal, in which one quarter you sell to them and then two quarters later there’s a consulting-services agreement coming back. Not all of that is fraudulent, but it’s something that really ought to raise suspicion.
If you don’t catch fraud by watching your collections, your returns, or your contracts, the last place you’ll see it is going to be in customer confirmations. Given the threat of jail time, most customers are not going to lie when they respond to an auditor’s confirmation letter.
So how do you sensitize yourself? You have to learn to identify the pressure points in your business. Then you want to look at the quality of your revenue: Who are we selling to? Are we collecting it? If you just made the quarter, look again, because that usually leads to problems in the next quarter or suggests that you are reaching a little too far. And then at the end of the day, if the cash isn’t coming in the door, look for it.
