Small Cues – Major Effect: How an Auditor Training Exercise Revealed a Multi-Generational Fraud
Part 1 of 2
Dr. Eddward T. Herron, CPA
Dr. Katherene P. Terrell, CPA
Dr. Robert L. Terrell, CPA, CIA
The case of the Farmers & Merchants Bank is based on a series of actual frauds perpetrated over a period of six decades. Two auditors uncovered the fraudulent behavior during a training assignment involving an experienced commissioned bank examiner (CBE) and a neophyte bank auditor. Their discovery process developed from the application of certain audit practices and procedures and their judicious attention to details, plus the intuitive experience of the CBE. Only the names of parties involved and geographic locations have been changed to protect the identities of the innocent. The actual facts of the case remain true, but have been summarized in some areas. Due to the complexity of the crimes and the long time line of events, certain facts about individuals, that were not brought out in the trial but were discovered by the auditors during the course of their two-year investigation, are included. The reader might assume that this is a long portrayal of the case, but instances of fraud are rarely singular events. Rather, each fraud seems to be woven into a story of its own. Learning to suspect, detect, and decipher those stories is a large part of fraud examinations.
After revealing the timeline of events to readers from beginning to end in Part 1, the auditors (and the reader with them) will discover the frauds by a retrospective examination of events, as would happen in reality, in Part 2. The forward-moving story will also contain hints which will prove valuable during the backward-moving discovery process.
In early 1994, Eddie Coello and Lynne Kupcinet drove, at daybreak on a bleak winter morning, from the Federal Reserve Bank (FRB) of Oklahoma City to inspect a small bank in Gravois, Oklahoma. A recent Ivy-League college graduate, Lynne was smart, articulate, and aggressive, intending to rise through the Federal Reserve’s ranks as quickly as possible. She planned to transfer to the Board of Governors within three years as a Commissioned Examiner, though commissioning usually took longer. Unknown to Eddie, she requested him to be her trainer because he was reputed to be especially thorough. Lynne knew Eddie had been commissioned in less than three years and she wanted to know how he did it. Otherwise, Lynne thought trainers were merely a necessity until she could, and certainly would, surpass them
Eddie Coello came from a tough, inner city neighborhood where, statistically, he should never have graduated from high school or from a second-tier state university. Grateful for the good fortune to survive his upbringing and to receive the opportunity to work for the Federal Reserve, he never stopped pushing himself to work harder and smarter than others. He thought trainees were merely extra weight to be carried until he could return to more serious work.
Growing up, Coello had observed many criminal acts and perpetrators, from petty crime to occasional felonies. Although he was not interested in participating in wrong doing, he found he enjoyed observing street behavior and talking with friends, and others who were more criminally inclined, about their motives, rationale, and techniques. He was not particularly saintly, as some mockingly called him, just curious. The better criminals, he observed, approached their work professionally and were better at playing games of strategy.
As they drove, Lynne peppered Eddie with questions about the training assignment – the institutional profile, management structure and governance, financials, strategic plans, prior examination data (especially the confidential sections not disclosed to the public), history, correspondence files, and so forth. He was surprised to hear so many questions from a trainee.
“It’s a training assignment at a very small bank,” he said. “Don’t expect too much at first. We probably won’t find much.”
‘Typical trainer,’ she thought. Without missing a beat she replied, “We find what we find. I just don’t want a watered-down experience because of the institution’s lack of complexity or some pre-conceived idea my trainer may have about what we probably won’t find.” Then, deferring to his seniority, she added, “If you don’t mind.”
Eddie thought ‘smart aleck know-it-all,’ but replied, “No, I don’t mind. If you like, as boring as it’ll likely be, we’ll make sure you have the full examination experience. But, you’ll have to do a lot more work.”
“I finished my college honors program in three years,” she answered, “so work has never been an issue for me.”
During the four-and-a-half hour drive, they spent most of the time discussing every detail of the assigned job, plus audit strategies, pre-planning, and more. After the first hour, Eddie suggested that Lynne keep a journal or a small recorder on her at all times.
“The most experienced people won’t be around you forever. Learn everything you can from them, about anything and everything – but make sure it’s not just conversation that you may not remember later on.”
Hint: Trainees should recognize that the responsibility for learning is theirs—and that trainers are assigned only to assist their learning.
The Story – Beginning to End
The Farmers and Merchants Bank (F&M;), in the southeast Oklahoma town of Gravois, was chartered in early 1929. Despite its inauspicious inaugural year, the bank survived the Great Depression largely because it was too new to have many loans on which to default. Fortuitously, its only competition was an already established bank with a robust loan portfolio, which became insolvent and was closed. Without competition, F&M; grew with the town for quite a long time. Decades later, when environmental laws began to make local coal mining unprofitable and the prices of agricultural products fell young people started to leave Gravois, taking their deposits and loan needs with them. The town grew older, literally and figuratively, and eventually the number of pensioners outnumbered working adults by almost two-to-one. Over time, F&M; grew old with the town.
Hint: Adverse structural economic changes should alert fraud examiners and auditors to the potential for increased pressure to commit fraud.
Jessup and Gordie Schmidt
F&M; was a family-controlled and operated institution. Founding President Jessup Schmidt employed his two sons at the bank from the very beginning. His elder son enlisted in the army during World War II, however, earning two purple hearts and a bronze star before being killed in battle a few months before the war ended. Heartbroken, Jessup gradually lost all interest in the bank. His surviving son, Gordon (Gordie), remained state-side during the war, where the opportunities for social and monetary advancement increased proportionately as the supply of young patriotic men dwindled. Gordie increasingly assumed more of the managerial duties at the bank from his grieving father, eventually taking over the bank’s management before Jessup’s death in the late 1940s.
Unlike his father, Gordie was willing to risk loans to marginally solvent borrowers, especially when potential profit margins for the bank were high. With his gambling spirit, he also looked for new business opportunities only loosely linked, if at all, to banking. He believed that business was a game like any other, where the only real objective was to win. The prize to be won was money which, especially in a small town, led to power.
Gordie had a talent for understanding and manipulating rules, so bookkeeping and regulatory guidelines placed no real constraints on his business strategies. He became a master at off-book banking and would often engage in non-documented hand-shake deals, using cash transactions and money orders whenever possible to avoid anyone tracing his activities. An example of his off-book banking may involve receipting, but not recording, a large customer deposit, then making an equity or debt investment in a business that he, or someone close to him, owned. The customer was usually unaware that his deposit was not legally booked. Gordie had given him a passbook, after all, and handled his deposits and withdrawals personally. Other times, Gordie would invest in a business opportunity, but have others listed as the owners of record and note them as having borrowing money from the bank. A variation on this theme was to have family or friends borrow more money than needed for their legitimate business interests, allowing Gordie use the excess funds for his own purposes as long as he committed to paying back both principal and interest on the funds he used. Sometimes, in fact, unrelated borrowers did not even know that their official loan balances were more than they intended to borrow. Gordie would simply add an amount to their requests for his own use. This sort of sophistication required both a double set of accounting records and rigged documentation records.
Gordie believed that the smartest cat in the jungle should be allowed to live life on his own terms. Game-playing, he believed, was a necessary part of life because he was limited in his self-dealing by regulatory rules and guidelines. In a sense, it was the regulators’ fault he had to go to such lengths to conceal his business dealings! Besides, he rationalized, he would repay the loans from the profits of the new businesses; so no one was really harmed in the deal.
Gordie would also create “handshake employment opportunities” to repay personal debts or pay for personal acquisitions by hiring creditors’ friends or relatives at F&M.; The bank, therefore, paid his bill. But, since the payment scheme was couched in terms of an operating expense for the bank, the after-tax cost was lower than it would have been to him personally. The actual amount of work done by those temporary employees, moreover, was a negotiable arrangement. “Why not let Uncle Sam pay for it,” and, “Let’s just pay for it out of taxes,” were two of Gordie’s frequently used expressions. When people asked Gordie if he was worried about being found out or charged with misdeeds, he would simply respond, “Let ‘em prove it.”
Proof of any wrongdoing would, indeed, be difficult to discover. Not only was there an inordinate number of cash transactions, but the bank’s part-time internal auditor was a relative, as was the bank’s chief accountant. The head teller, the vice-president in charge of lending, the branch manager, and the janitor were also relatives. Every other employee working for the bank was either a friend or a close relative of Gordie’s friends and business associates.
Although this practice was inconsistent with good internal controls, it was a small bank, and local people believed Gordie was trying to lend a helping hand to the towns-folk. Whenever auditors or other outsiders discovered errors, moreover, Gordie could always blame his poorly educated, elderly cashier, Miss Pitt. Yet, Gordie explained, he couldn’t bear to fire or retire her. Where else could she find a job, after all? People seemed to feel compassion for “poor ol’ Gordie,” trying to succeed in small-town banking while employing so many people who were unlikely to find work elsewhere. Not surprisingly, his sympathetic persona, coupled with a reputation for resourcefulness in financing most of the business proposals brought to him, cast him in the role of local hero. The few who did not understand his reluctance to make necessary changes, or who refused to accept his excuses for improprieties, eventually left him alone after he sincerely promised to make necessary reforms
Hint: Poor internal controls (especially ongoing), nepotism, frequent cash transactions, and excessive CEO influence in day-to-day operations should alert fraud examiners and auditors to the potential for individual and/or collusive fraud (Rezaee & Crumbley, 2007; DiGabrielle, 2009)
F&M;’s loan portfolio grew rapidly during Gordie’s reign. Although his managerial practices piqued the interest of more conservative bank examiners or auditors from time-to-time, , Gordie was always able to handle them with a few relatively simple tactics. His favorites included providing them with snacks and beverages throughout the day, taking an especially long time to provide necessary documentation, and arranging special discounts for “government workers” or “Gordie’s friends” at the local diner. Gordie learned early on that well-fed people are more content, and that people cannot really work when they are eating or waiting. Most auditors and examiners have a limited time schedule, so wasting their time by having them wait (even on legitimate documentation) means they have less time to explore more controversial matters. Ingratiating himself with them was also effective because, as he said, “Folks will give you the benefit of doubt if they like you, and folks especially don’t like to criticize people they like.”
Although Gordie was a shrewd businessman, he sometimes gambled on questionable loans or investments and lost. Even his charming public persona could not mitigate those problems. Early in his tenure at the bank, he lost a large amount of money when a commercial real estate project failed, and could only be sold for a fraction of what he had loaned on it. Coincidentally, that was when he decided to marry Mary Anne, daughter of the wealthy and locally prominent physician, Daniel Evans. Dr. Evans became a significant shareholder of F&M; shortly thereafter, buying approximately 25 percent of the bank’s stock, and probably saving it from insolvency.
To Gordie, marriage was like business – largely another game to be played. So, his marriage to Mary Anne certainly did not prevent him from living life on his own terms. He made frequent business trips to Oklahoma City and Dallas before and after their marriage, where he enjoyed a decadent life. Neither bank examiners nor auditors ever seriously questioned the reasons a small-town Oklahoma banker needed to visit those cities for legitimate business purposes. To Gordie, their reticence amounted to tacit approval for his travel costs.
Hint: Frequent, even infrequent but apparently unnecessary, business expenses are often symptomatic of fraudulent activities.
Gordie thought he had the best of everything, except an heir to his empire. The couple had only one child – a daughter, Mary Elizabeth. Liz grew up away from her father’s personal or business affairs, but she heard enough whispers and rumors to suspect that he was less than fastidious with his associations. Still, she tried to be obedient to her parents’ wishes, even in the selection of suitors. Liz had dated two or three young men whom Gordie did not like because they lacked what Gordie called “street smarts.” One fellow though, who had shown an interest in Liz while he was working as summer help in the bank, was more to Gordie’s liking.
James J. Jackson, or J.J., grew up in Gravois. He was an especially athletic, if academically challenged, student. As a very personable local sports celebrity, he could choose to work at any of the local businesses during his summer breaks, but selected F&M; – at least partially due to Liz Schmidt. Liz represented a lifestyle that J.J. had only fantasized about, with money, prestige, and social opportunities.
J.J.’s family was poor. His father had left the family when J.J. was twelve, and J.J. always yearned for a father figure to mentor and advise him. He thought that Liz had the kind of father a guy could only wish for – a smart, self-made man of wealth, whom everyone seemed to like and nobody dared to cross.
Gordie and J.J. hit it off immediately. Each was a local hero of sorts, and each wanted what the other had to offer. Liz’s initial reluctance to date J.J. was mitigated by her father’s persistent praise of the youth and by the fact that J.J. was, after all, one of the most popular guys in town. Liz found J.J. to be a bit shallow, but personable, polite, and athletically handsome. J.J. found Liz to be kind and understanding, and the kind of woman he imagined would be a good mother. They were married about eighteen months after high school graduation. To her, it was an agreeable-enough pairing. To him, it was the chance of a lifetime.
At the bank, J.J. started at the bottom, working up through teller, loan teller, repossession man, and consumer loan officer. J.J. seemed to thrive at the bank, and he was eventually promoted to commercial loan officer and then Vice President of the bank. He reached VP in about ten years, and it was a well-deserved promotion. The townsfolk loved seeing the rise of J.J. Jackson, and they loved Gordie even more for making J.J. “work for a living.”
J.J. thoroughly enjoyed working in the bank, and especially with Gordie. Of course, J.J.’s work titles were only meant to be a façade to appease onlookers and bank examiners. J.J. was always paid more than enough to support him and Liz quite comfortably. But J.J. genuinely liked to move through various departments on his way up the ladder and learn as much as possible from Gordie about each of those areas. J.J. may not have been an honor student in high school, but he was a clever and intelligent man. Gordie was also pleased to have someone to teach all that he had learned throughout his banking career.
Gordie treated J.J. like the son he never had and reveled in J.J.’s success at improving on, or even expanding, Gordie’s own schemes. J.J. learned everything about how Gordie handled his business, including occasional business trips to Oklahoma City or Dallas. The two became inseparable until Gordie’s death in the early 1960s.
It seemed that J.J. and Liz had everything they could ever want. He had become as successful a banker as his late father-in-law, despite the changing economy. Meanwhile, Liz had borne three healthy children – James Jr. (“Jr.”), Judy, and John—and J.J. could clearly imagine his dynasty growing.
J.J. proved to be a doting father, especially protective of Judy. His clear intent for his sons was that they should follow in their father’s footsteps. J.J. set about training them, passing on to them the business practices that he had learned from Gordie, as well as his own ideas. He also let them test their own business skills by setting up small, undisclosed companies that were usually funded either directly or indirectly by F&M;, much as he and Gordie had done. At the appropriate time, J.J. also began taking his sons along on business trips.
It may have been during one of those trips in the mid-1980s when J.J. discovered that Jr. lived an alternative life style. Fearing the small-town shame to which he might be subjected, J.J. banished his son from his presence for many years. While the local folks seemed to understand and even empathize with J.J., Liz could neither understand nor tolerate J.J.’s actions. Sometime in the years before Jr.’s revelation, J.J. had convinced Liz to transfer her controlling interest in the bank into his name. He appealed to her on grounds that the local community saw him as a “kept man”, arguing that the stigma would be bad for business in the long run. She reluctantly agreed, largely because she was taught to acquiesce to patriarchal authority. Now, after J.J. had thrown one of their children out of the house, Liz regretted that decision. During the ensuing disagreements, Liz told J.J. that, if he insisted Jr. leave their home, she would do likewise. J.J. reportedly responded that he no longer needed her, and even revealed the true nature of his business trips. So far as he was concerned, in fact, she was no longer welcome in his home, his life, or his bank.
Liz promptly moved out of their home but, in defiance, kept her seat on F&M;’s board of directors. During a board meeting several months later, their feud came to a head when J.J. began belittling Liz for her lack of banking acumen. During the increasingly raucous argument that followed, Liz announced she was leaving J.J. for another board member, Clinton Ferris, M.D. Dr. Ferris had acquired Dr. Evans’ holdings in the bank about three years earlier. Hint: Unprofessional public behavior of personnel, especially by executives, should alert fraud examiners and auditors to potentially increased pressures that may eventually contribute to committing fraud.
When Liz filed for divorce, J.J. initially refused to agree to alimony payments. After she reminded J.J. of her knowledge about his off-book banking and other schemes, however, he agreed to payments – but on his own terms. Liz relocated to California and found work in another bank as an administrative assistant. Yet she retained her seat on the board of F&M; and received $5,000 in tax deductible “director’s fees” for each monthly board meeting, whether she attended or not. F&M; also reimbursed Liz for her travel expenses when she flew back to Oklahoma to attend the meetings, which she did when they coincided with one of her children’s birthdays or a major holiday. Notably, it was understood that her board seat would be terminated if she remarried.
When dealing with the bank examiners, J.J. skirted the issue of payments to Liz in two ways. His first maneuver was to form a shell holding company to purchase the bank as its sole asset. He then moved the payments from the bank to its new parent company, which was examined by a different group of regulators, and much less frequently than was the bank. Legally, therefore, the payments to Liz were not bank expenses, per se, and could not be questioned by bank examiners during their bi-annual visits. Only bank holding company inspectors could question the payments, and their visits to the small, shell holding company were rare. J.J.’s other stratagem was to argue with the holding company examiners that, given her long tenure at the bank, Liz provided an important and necessary knowledge base.
J.J.’s Business Ventures
Small, shell holding companies were generally considered only marginally important to regulators and, following the Savings and Loan and farm debt crises, received scant attention unless there was reason to believe that serious abuse was occurring. Consequently, J.J. jousted with regulators over the payments to Liz primarily through the mail. His success in convincing the examiners that the payments were legitimate emboldened J.J. to consider moving other operations - payments or activities that bank regulators could not and would not overlook at the bank - “upstream” to the books of the holding company.
J.J., like Gordie, had funneled bank funding into many business ventures on his own behalf. But, for the most part, he failed to report them to banking regulators. These ventures included every sort of small town business: restaurants, shops, kiosks, used car dealerships, furniture stores, handmade brooms, and more. Each business was held in someone else’s name so it could not be connected to J.J. Required reporting of personal business interests is a regulation aimed at preventing bankers from self-dealing. Otherwise, bank owners could effectively loan their own business interests (i.e., themselves) a multiple of their supposed investment in the bank and, on a net basis, have contributed nothing at all to the bank’s capital, or even have a net-negative investment in the bank on an effective basis.
J.J.’s modus operandi was just that – secretly funding his own business interests. He was reasonably successful in financing those ventures, so his next logical step was to finance fictitious businesses. Concealment was relatively easy since sampling techniques were known to him, and small loans were scarcely reviewed by auditors or bank examiners.
In the early 1990s, J.J. became increasingly interested in health and pseudo-health businesses, especially tanning and toning equipment. These small businesses were usually only marginally sound, however, due to high overhead and equipment costs and a low fee structure. Still, after visiting a few trade fairs to examine the equipment, J.J. began to hatch his greatest scheme.
J.J. learned that some tanning salons diversified their risks and income streams by expanding into toning equipment to help (mostly) convalescent people strengthen their bodies. To J.J., the idea of bringing additional market segments into these small salons seemed almost perfect. After all, diversification could lead to larger operating margins, maybe even enough to properly service their debt loads. For smaller operations, though, financing would continue to be a problem. J.J. considered carving out a market niche for F&M; by financing tanning and toning salons throughout the U.S. The local economy had been stagnant for several years, and J.J.’s idea was a relatively novel way for the bank to grow. He believed that a smart entrepreneur like himself could find other ways to make money on such a scheme.
Hint: Material changes in either the mix, or rate of change, in balance sheet and/or income statement accounts should warrant investigation. Immaterial differences, however, should also be examined when other indicators of misconduct are present.
J.J. decided to blitz the national market for F&M; to offer business financing for tanning and toning salons through either direct loans or lease financing. He developed a team that worked national trade shows to entice attendees to enjoy the benefits of owning their own businesses – largely financed, of course, by F&M.; Easy financing for the borrowers, moreover, meant that the terms were especially favorable to the bank. Simultaneously, J.J. set up a “consulting” arm of the operation to advise new business owners on beginning and/or running their own small businesses, franchising his own business model to those who were reluctant to fly solo. His largest contrivance, however, was to set up a manufacturing business to produce the very equipment he would eventually finance.
In summary, J.J. would own an ostensibly independent manufacturer of toning equipment and then, in turn, provide loan funding to borrowers wanting to purchase that equipment. If purchasing the equipment entailed too much risk for some salon owners, as it did for many, he would set up a leasing company funded by F&M; that would purchase the equipment and lease it to the salon owners. He would also reap consultants’ fees for helping establish many of the businesses. Finally, he would covertly own a few of the franchised operations himself.
Truly, the scheme was magnificent: J.J. would benefit indirectly through the bank’s formal loan and lease financing, and directly through the manufacture and sale of equipment, consulting and franchise fees, and franchise ownership. As usual, most of his direct benefits would be based on undocumented hand-shake transactions so no one, especially the banking regulators, would be the wiser. Being cautious, he borrowed money to fund a few of his own franchised salons from other banks, using fraudulent financial data to obtain the personal loans.
In a world of risks, J.J. estimated that there was a very low probability that things could go wrong with his scheme. Even if the loans and leases went bad and had to be written off, as many eventually did, J.J. spaced the write-offs so that the bank’s bad-debt allowances merely offset what otherwise would have been paid in income taxes if the losses had not been realized. Plus, repossessing the toning equipment from failed operations allowed the bank to recycle equipment through other salon owners and franchisees, recovering their losses through resale.
Bank examiners disliked the loan and lease operation from the start, but since it was initially profitable for the small town bank they took a wait-and-see approach. By the time the default rates for the loans and leases began to escalate, J.J. forestalled their criticisms by preemptively abandoning the business and humbly admitting that “maybe I made a mistake.” F&M had to realize some substantial losses, of course, but behind the scenes, J.J. managed the write-offs so that they merely whittled away at the bank’s annual tax bills. He estimated that, at an average tax rate of 39 percent, he could write off all he needed within three to five years without it effectivelycosting the bank very much on a net-after-tax basis. Meanwhile, he continued to benefit from his direct business ventures.
The regulators were apparently appeased by J.J.’s repentance and promise of reforms, including his willingness to recognize the substantial losses without regulatory pressure and his offer to step down as CEO. To a number of regulators something still did not seem right, but it appeared that J.J. was doing all he could to remedy the situation. It seemed unlikely that he would deliberately jeopardize his biggest investment – the bank.
Hint: Nominal acts or promises that result in little or no real or effective change should alert examiners and auditors to increase the scrutiny of accounts and transactions.
In reality, of course, J.J.’s repentant nature and promised reforms were all part of a well-conceived contingency plan. Even his offer to step down as CEO was contrived - he had planned to officiallypass the reigns of management to either the bank’s Vice President in Charge of Lending (his first cousin) or to the Executive Vice President in Charge of Operations (his second cousin). Meanwhile, he would retain his position as CEO of the bank’s holding company. In reality, no decision would ever be made at the bank without J.J.’s prior approval.
The Beginning of the End
J.J. realized that he was having problems when his hand-shake business partnerships began to disintegrate. He had set up a manufacturing company in New Jersey, where he found two unscrupulous fellows with whom he felt he could do undocumented business. Things went well as long as orders for the low-grade-but-high-priced equipment escalated. As the equipment orders eventually slowed, however, there was not much money left over after J.J. paid himself. Before too long, J.J.’s partners unilaterally dissolved the partnership and pressed J.J. for more money to cover their own expenses. J.J. had little fear of his business partners turning him in, though, because each partner had dirty hands of his own, and would be reluctant to speak to any law enforcement agency.
A more direct threat was another undocumented business associate whom J.J. had hired to manage (i.e., ostensibly own) J.J.’s franchised salons. Larry Fellows was J.J.’s life-long friend and, being between engagements at the time of J.J.’s offer, agreed to own (in name only) and manage (in fact) certain businesses. After several months, however, Larry and J.J. reportedly argued over a female employee of a Dallas salon. Thereafter, Larry began treating the businesses as if they actually were his – taking money from the cash registers, hiring his own friends and relatives, occasionally firing J.J.’s hires, and generally becoming an expensive nuisance. Yet little could be done because Larry technically owned the businesses and, even though Larry had been in trouble with the law in the past, his hands were currently clean.
J.J.’s eventual downfall, however, was due to his own sentimentality. His eldest son, James Jr., had lived away from home since J.J. threw him out several years before. Through his ex-wife Liz, J.J. learned that Jr. had contracted a potentially terminal disease and needed health insurance to prolong his life. J.J. not only invited his son back into his life, but he concocted yet another business that would allow him to provide group coverage health insurance and good salaries to both Jr. and his partner.
J.J. set up Jr. and his partner in a credit analysis business. Since neither had any prior experience in that profession, F&M staff secretly provided them both with free training, before hiring the company to provide credit analysis services for the bank. The credit analysis business was informally owned by J.J., but officially registered in Jr.’s partner’s name. Bank regulators did not want the bank to have anything to do with the leasing operations; so long-term contractual payments to the (ostensibly) independent credit company were shifted to the holding company. Those payments continued for another two years – even after J.J. essentially shut the leasing operation down to mitigate bank examiners’ concerns.
By the time the loan and lease operation had run its course, J.J. had made a very large sum of money and was thinking of retirement. In total, J.J. and some of his associates had engaged in hundreds of frauds and instances of insider abuse of banking operations, including: loan fraud (one fraud for each borrower and lessee, one for each fictitious business loan, and one for each of J.J.’s personal loans to finance his own undisclosed salons); financial statement fraud (on average one fraud for each case of loan fraud, plus one count for each bank and bank holding company financial statement submitted to regulatory authorities); failure to report insider loans, either direct or indirect; failure to report executive business interests; deliberately concealing material facts, deceiving and lying to federal banking authorities; and, tax fraud—both at the personal and business levels.
J.J. had relied on collusion, cash (or near-cash) transactions, and undocumented business arrangements to carry out his schemes. Even highly experienced bank examiners and auditors would find it difficult to overcome those tactics. J.J. had also successfully relied on a keen understanding of materiality levels, auditor procedures, and the approaches of bank examiners and auditors. He was especially aware of their reluctance to talk to one another, to venture off-site to compare notes with others, or to physically check the value and veracity of collateral. Furthermore, he usually divided large frauds into very small, related frauds and criminal acts that generally remained under the radar of bank examiners and auditors.
The discovery of fraud began to unfold because Eddie and Lynne returned to a principles-based examination, which set materiality levels extremely low. Ordinarily auditors and examiners would not revert to low levels of materiality without more, or at least some, evidence of criminal wrongdoing – except in the case of a training exercise. Additionally, Eddie believed in assessing non-financial evidence, and evaluating the veracity of collateral values – like the value of repossessed toning equipment. Additionally, experienced auditors and examiners know that there should be a synchronization of financial and non-financial cues. When they seem at odds, something is afoot. J.J. Jackson had fortified himself against the risks from potential investigations by experienced examiners and auditors. His fraudulent escapades, however, came to an end as the result of this innocuous training exercise. Every fraudster, it seems, has his or her own Achilles heel.
Hints: Dramatically lowering materiality levels may disrupt and/or reveal small-unit frauds. Auditors should always use random variations in materiality levels from year to year (Terrell, Terrell & Herron 2011). Non-financial evidence should always be assessed vis-à-vis financial evidence, and vice-versa. The veracity of collateral documentation and estimated values should be assessed at least on a sampled basis.
Part 2 of this paper, forthcoming, will describe the audit assignment and trace the efforts of the auditors in reconstructing the story.
Dr. Eddward T. Herron, CPA is an Assistant Professor of Accounting at the University of Wisconsin – La Crosse. He is relatively new to academia, having worked in regulatory auditing, banking supervision, fraud examination, and bank consulting for more than twenty-two years both domestically for the Federal Reserve and internationally for the International Monetary Fund. He teaches managerial and financial accounting, auditing, and fraud examination. Dr. Herron holds Baccalaureate degrees in Economics and Finance, Master’s in both Business Education and Accounting, and a Doctorate in Accounting. He is a Certified Public Accountant as well as a Commissioned Examiner by the Board of Governors of the Federal Reserve System.
Dr. Katherene P. Terrell, CPA is a professor and chair of the Accounting Department at the University of Central Oklahoma where she teaches financial accounting. Dr. Terrell has co-authored several textbooks and journal articles. She has been honored with a number of teaching awards including the OSCPA’s 2004 Oklahoma Outstanding Accounting Educator award and service awards including the UCO 2002 Modeling the Way Award. Concerned with ethical behavior, Dr. Terrell coaches the UCO Ethics Teams that participate in Oklahoma Student Ethics Challenges, the Texas Regional Ethics Bowls, and the 2014 National Ethics Bowl. She has taught accounting for 26 years at UCO after a 23-year career in public accounting as a partner in Terrell & Terrell, CPAs. Dr. Terrell has a BBA in Accounting from the University of Oklahoma, an MBA in Accounting from the University of Central Oklahoma, and an EdD from Oklahoma State University
Dr. Robert L. Terrell, CPA, CIA is a professor of accounting at the University of Central Oklahoma teaching in the areas of auditing, fraud, ethics, and financial accounting. He has co-authored several accounting textbooks and journal articles. Dr. Terrell has won numerous teaching awards including the 1994 Oklahoma Outstanding Accounting Educator award from the Oklahoma Society of CPAs, the Carnegie Foundation 2008 Oklahoma Professor of the Year award, and the 2014 Outstanding Educator for the Region by the ACBSP. Dr. Terrell earned a BBA in Accounting in 1969, an MBA in 1971 from the University of Oklahoma, and an EdD from Oklahoma State University in 1992. Dr. Terrell began teaching accounting in 1970. He also practiced public accounting for 23 years with the firm of Terrell & Terrell, CPAs. Dr. Terrell frequently provides continuing professional education seminars in the areas of ethics and fraud.
Apostolou, N. & Crumbley, D. L. (2008). The tally stick: The first internal control? The Forensic Examiner, 17, 60-62. Retrieved from http://www.forensicexaminer.com/
DiGabriele, J. A. (2008). An empirical investigation of the relevant skills of forensic accountants. Journal of Education for Business, 83, 331-338. Retrieved from http://www.eric.ed.gov/ERICWebPortal/recordDetail?accno=EJ805272
DiGabriele, J. A. (2009). Fishbowl the forensic accountant: A closer look at the skills forensic accounting education should emphasize. The Forensic Examiner, 18 (2), 72-74. Retrieved from http://www.forensicexaminer.com/
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Rezaee, Z. & Crumbley, D. L. (2007). The role of forensic auditing techniques in restoring public trust and investor confidence in financial information. The Forensic Examiner, 16 (1), 40-49. Retrieved from http://www.forensicexaminer.com/
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Terrell, R. L., Terrell, K. P. & Herron, E. T. (2011). Use random variation of audit procedures and soft cues to better detect fraud. CPAFocus, 12 (3), 16-17. Retrieved from http//www.oscpa.com/
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