Detecting Fraud Through Vendor Audits

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1 Detecting Fraud Through Vendor Audits Identifying and Selecting Audit Candidates 2017 Association of Certified Fraud Examiners, Inc.

2 The Importance of Routinely Exercising Vendor Audit Rights There is a significant reduction in vendor audit costs and overbillings. Compliance is increased by both employees and vendors. Organizational policies and procedures are strengthened. Vendors know what to expect from audits, what documentation to keep, and where their processes are generating overbillings Association of Certified Fraud Examiners, Inc. 2 of 27

3 The Importance of Routinely Exercising Vendor Audit Rights Audit staff is more adept at conducting the audits and knowing what to look for. Contract and audit clause language is improved based on other vendor audits experiences. Increase the perception of detection, decrease the probability of fraud. Company employees are aware that proactive vendor audits can uncover areas where they are not performing their jobs or are engaging in conflicts of interests or kickbacks Association of Certified Fraud Examiners, Inc. 3 of 27

4 Determining Which Vendors to Audit The first step in implementing a vendor audit program is to determine who to audit. The technique used is largely based on the type of contract, the goals of the audit, specific concerns of management, and other relevant variables Association of Certified Fraud Examiners, Inc. 4 of 27

Total Spend Pros Allows for increased audit coverage Low recovery percentages could still add up to big dollars being identified Might be the best option when audit resources are limited Cons Larger

5 Total Spend Pros Allows for increased audit coverage Low recovery percentages could still add up to big dollars being identified Might be the best option when audit resources are limited Cons Larger companies might have better controls in place May forego the relative risks and variables of the contracts Could keep the audit team from assessing low to medium level 2017 Association of Certified Fraud Examiners, Inc. 5 of 27

6 Number of Invoices Most invoices High number of invoices increases the chances of errors and makes it easier to hide manipulation May be significantly more work for the audit team if statistical sampling and extrapolation is not allowed Fewest invoices Invoices and supporting documentation might be so large that additional items can be inserted Invoices could be for significant amounts, but lack supporting documentation or have very short descriptions of the service 2017 Association of Certified Fraud Examiners, Inc. 6 of 27

7 Number of Contracts The number of contracts involved, coupled with variations in terms and conditions, inevitably complicates the billing process. Vendor can use higher rates in one contract on invoices that should have lower rates. With the number of contracts, invoices, service areas, invoice entry points, and contract management points, there could also be an increased risk of double billing or cross billing on the wrong contracts Association of Certified Fraud Examiners, Inc. 7 of 27

Sole- or Single-Source Contracts Risks: Increased potential for conflicts of interests Business inappropriately pushed to certain vendors Increased

8 Sole- or Single-Source Contracts Risks: Increased potential for conflicts of interests Business inappropriately pushed to certain vendors Increased potential for shell companies Insufficient time spent reviewing the contact terms or vendor invoices 2017 Association of Certified Fraud Examiners, Inc. 8 of 27

9 Sole- or Single-Source Contracts Number of sole-source contracts by vendor Sole-source contracts by dollar amount Sole-source contracts by total number of change orders Sole-source contracts with largest percentage change order amount over original contract amount 2017 Association of Certified Fraud Examiners, Inc. 9 of 27

10 Top-Ten Tests Contracts By value Employees Vendors Who issued the most contracts Who issued the most POs Who approved the most invoices Who approved the most spend With the most contracts With the most total spend With the most change orders With the most sole-source contracts With the greatest number of invoices 2017 Association of Certified Fraud Examiners, Inc. 10 of 27

11 Benford s Law In the 1920s, engineer Frank Benford noticed that other engineers frequented log tables that started with the digits 1, 2, and 3 more than those that started with 7, 8, and 9. He experimented and determined that naturally occurring numbers follow a specific pattern. Ones Sixes Twos Sevens Threes Eights Fours Nines Fives Association of Certified Fraud Examiners, Inc. 11 of 27

12 Benford s Law 2017 Association of Certified Fraud Examiners, Inc. 12 of 27

13 Even or Round Payment Amounts The generation of invoice amounts is usually natural. Line items, rates, fees, markup percentages, and tax rates affect the final invoice amount, so the final number is relatively unknown and random. Even numbers or round numbers, while possible, should be few and far between. Unit rates or specific even-dollar charge amounts are an exception and may provide a false positive Association of Certified Fraud Examiners, Inc. 13 of 27

14 Invoice Sequence Non-sequential Sequential Invoice #12387 for $23, Invoice #12644 for $31, Invoice #13112 for $17, Invoice #1234 for $1,791 Invoice #1235 for $3,360 Invoice #1236 for $4,515 Invoice #1241 for $4,131 Invoice #1242 for $2,372 Invoice #1243 for $1,104 Invoice #1255 for $3,836 Invoice #1256 for $2,318 Invoice #1257 for $1, Association of Certified Fraud Examiners, Inc. 14 of 27

15 Contractor/Subcontractor Selection Method Identify vendors that frequently work together as contractors and subcontractors. Analysis can help uncover unknown relationships, intentional markups, overbilling, bid rigging or rotation, and other procurement issues. This requires very good contractor/subcontractor data Association of Certified Fraud Examiners, Inc. 15 of 27

16 Contractor/Subcontractor Selection Method Company Vendor A Vendor B Vendor C Vendor D Vendor E Vendor F Vendor C Vendor A Vendor A Vendor F Vendor F Vendor C 2017 Association of Certified Fraud Examiners, Inc. 16 of 27

90 invoice Project #2 Routine maintenance Vendor C is contractor Services performed

17 Contractor/Subcontractor Selection Method Project #1 $10 million new construction Vendor A is primary contractor Vendor C is listed as a sub Week of April 11 $16, invoice Project #2 Routine maintenance Vendor C is contractor Services performed on April 13 $2, invoice 2017 Association of Certified Fraud Examiners, Inc. 17 of 27

18 Payment-Method Comparison Might be difficult to perform or irrelevant depending on accounts payable data. Identify vendors who are paid differently than the bulk of the vendors. Compare payment methods used for vendors in similar categories. Might be helpful in identifying shell companies Association of Certified Fraud Examiners, Inc. 18 of 27

19 Vendor Touch Points How many places can a vendor submit an invoice for processing? Identify the number of employees who have approved invoices. Identify the number of contract managers with whom a vendor may be working. Requires fairly good procurement and accounts payable data Association of Certified Fraud Examiners, Inc. 19 of 27

20 Payment Trend When are payments entered and processed? Are payments made on weekends, holidays, or during extended hours? This might indicate that someone is processing defective invoices during off-peak times. Compare payment terms to actual payments. Compare all invoices for a specific vendor and/or the average payment time frame across several vendors. Look for vendors receiving favorable payment terms. Example: Net 45 days listed in system, but the vendor is paid on average in four days Association of Certified Fraud Examiners, Inc. 20 of 27

21 Vendor Refunds or Reversals This might indicate that the vendor has an inadequate system for generating invoices. There might be additional concern over the number of errors that have made their way through the payment process unnoticed. Refunds or reversals at the end of accounting cycle could be an attempt to manipulate budgets Association of Certified Fraud Examiners, Inc. 21 of 27

22 Length of Time With Company Old vendor May have knowledge of accounting and billing weaknesses Relationships, conflicts of interest, bribery, kickbacks May be significantly integrated and overly relied upon for services (trust) May receive preferential treatment over other vendors New vendor New status and growth may be result of internal relationships Could be completely fictitious entity or a shell company May have processes that are unable to keep up with new growth 2017 Association of Certified Fraud Examiners, Inc. 22 of 27

23 Climbers and Divers Analyzing the overall spend across a category of vendors for a period of time: Goal: to identify abnormal growth or reductions in spend at certain vendors Significant growth or decline might indicate: Change in quality or routine business issues Disagreements between the vendor and management Failing to pay kickbacks or new corruption Retirement and start up of new shell companies Bid rigging 2017 Association of Certified Fraud Examiners, Inc. 23 of 27

24 Climbers and Divers 2017 Association of Certified Fraud Examiners, Inc. 24 of 27

25 Outlier Testing Requires access to good accounts payable data. Run data analytics against payments for the last 1 5 years. Look for vendors who have invoices that exceed their 12-month moving average by 200%. Review outliers to determine significance. Might help identify double billing issues such as bundling Association of Certified Fraud Examiners, Inc. 25 of 27

26 Similar Groups or Competitor Comparisons Review vendors that offer similar services or are competitors to see whether they show different variable trends over time (e.g., the number of contracts, invoices, average spend, total spend) Allows the audit team to focus on a smaller subset of vendors and better analyze the variables Also helps the audit team refine the knowledge, skills, and abilities needed to audit the particular vendors and services 2017 Association of Certified Fraud Examiners, Inc. 26 of 27

27 Similar Groups or Competitor Comparisons 2017 Association of Certified Fraud Examiners, Inc. 27 of 27

28 Criticality of Goods and Services Rendered Is vendor heavily relied on to provide component or support products? Is vendor one of a limited number of raw material suppliers? Does vendor provide key consulting services that the organization relies on? 2017 Association of Certified Fraud Examiners, Inc. 28 of 27

29 Criticality of Goods and Services Rendered Does vendor provide the bulk of the major construction support or oversight functions? Is vendor a clearinghouse for the organization s cash (i.e., a payment processor)? Is vendor fully integrated and relied on in the normal function of the organization? 2017 Association of Certified Fraud Examiners, Inc. 29 of 27

30 Complaints, Issues, and Disputes Vendors that routinely come up in complaints from frontline supervisors, procurement staff, administrative staff, or accounting staff Vendors that routinely fail to deliver on time, deliver the wrong goods, arrive late, leave early, or have chronic invoice problems Past investigations and hotline complaints Public records search on major/minor vendors U.S. government s System for Awards Management (SAM) 2017 Association of Certified Fraud Examiners, Inc. 30 of 27

Managing Fraud Risks. Procurement & Contacting. John J. Hall, CPA (970)

Managing Fraud Risks. Procurement & Contacting. John J. Hall, CPA (970) Managing Fraud Risks in Procurement & Contacting The IIA Los Angeles Chapter October 2, 2017 John J. Hall, CPA (970) 926-0355 John@JohnHallSpeaker.com 1 Four Categories 1. Theft 2. Results Manipulation