Small Cues – Major Effect:  How an Auditor Training Exercise
Revealed a Multi-Generational Fraud
Part 2 of 2

Dr. Eddward T. Herron, CPA
Dr. Katherene P. Terrell, CPA
Dr. Robert L. Terrell, CPA, CIA


Research has shown that forensic accountants and auditors must possess certain skills and abilities that avoid routine behavior in audits.  This requires the abilities to notice the unusual, to use unstructured problem solving skills and critical thinking, to perform audits with flexibility, to have the composure to calmly continue the investigation, and to understand the legalities required to successfully bring a case to justice (DiGabriele, 2008 & 2008).  No longer can auditors wear blinders by continuing routine audits without noticing the unusual behaviors that lead to discovering malfeasance (DiGabriele, 2011).  Auditing education has centered on the professional rules of conduct, specific audit techniques, planning the engagement, and studying internal controls. Although the concept of internal controls date back 30,000 years to the tally stick (Apostolou & Crumbley, 2008), some are reluctant to understand how internal controls must be tested and evaluated to be relevant. Instead of following proscribed procedures year after year, all auditors must be aware of small cues that warn of potential problems in financial operations and reporting (Terrell, Terrell, & Herron, 2011). Forensic accounting requires a departure from the normal procedures and the recognition that small cues might hide major problems because fraudsters are very clever.  Rezaee, Crumbley, & Elmore (2004) found that educators believed cases and textbooks were the most effective means of teaching forensic accounting.

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 an innocuous 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 the geographic locations have been changed to protect the identities of many innocent and near innocent parties. 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, facts about the individuals are included that were not brought out in the trial but were discovered by the auditors during the course of their two-year investigation. 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 events to readers from beginning to end in Part 1, the auditors will discover the frauds by a retrospective examination of events from the end back to the beginning as it would happen in reality. Part 1 described a step-by-step journey through time and events until much was known. Along the way forward, the reader learned something about how and why frauds can happen, and along the way back will see how the auditors gathered evidence to prove the frauds did occur. The story in Part 1 sprinkled hints going forward, which will also prove valuable during the discovery process going backward.

The Audit Assignment

Bank Management

The auditors arrived in Gravois a little before noon and, after checking into their rooms at the Gravois Inn and having a light lunch, found their way to the bank by one o’clock. “The first thing I like to do,” Coello instructed, “is to meet with the CEO and talk about the bank. You discreetly take notes while I talk.” Hint: Try to ensure that more than one examiner/auditor is always privy to all interviews, and that any note-taking is done discreetly so the interview flows more naturally.

The examiners found the F&M bank management team to be exceptionally friendly and more than willing to discuss the affairs of either the bank or its bank holding company (BHC). The intent was to make an outsider feel welcome in J.J.’s little world. J.J. himself was a very likable person, after all, known for his southern hospitality like Gordie before him. Consequently, much of the bank’s colorful history was widely known and discussed. In that atmosphere, it was unusual that J.J.’s replacement at the bank, CEO (and J.J.’s second cousin) Cletus Schmidt, seemed hesitant to meet alone with bank auditors. Unknown to Eddie and Lynne at the time, most of the staff working at F&M were somewhat complicit with the fraudulent activities but they knew that Cletus, reputed to be an honest old “farm boy,” was not a good liar – even when he tried. The staff, therefore, had a vested interest in making sure Cletus did not spill their secrets.

Cletus’ reluctance to meet with examiners alone was not apparent at first. He attended introductory and initial meetings, although always with other bank officers in attendance, during which examiners verified off-site financial analysis and generally discussed strategies, plans, market opportunities, and impediments. At subsequent meetings, however, J.J. was always present and the obviously dominant bank representative, although officially he had voluntarily stepped down from bank management more than a year before. 

J.J. spoke of the bank’s history and its eroding market base, and of his own near-Herculean efforts to save it, including his admitted “poor choices” involving the loans and leases associated with tanning and toning equipment. Of course he was sorry, now that the bank had “lost so much!” Besides, it was a good thing that he had insisted “up front” on financing “only” the Cadillac of equipment as a failsafe against potential losses. Otherwise, who knows how bad the problems could have been? He painted the bank as a strict market participant in a golden opportunity: financing the Cadillac of tanning/toning equipment, rebuilding the local community, and even helping America create hundreds of small businesses and jobs. When asked about the related companies, J.J. maintained that F&M had a strictly arms-length relationship with all of its loan/lease clients and with every other party in the scheme’s economic chain – including the equipment manufacturer and the credit rating company the bank was using to evaluate the deluge of loan/lease applications associated with the tanning/toning equipment debacle.

Meetings with the bank’s supervisory staff would usually suffice when auditors were looking for abnormalities under normal circumstances, but this particular bank audit was a training assignment. Consequently, the training process warranted that the trainee had at least some exposure to strictly CEO meetings – if only to discuss general strategies, business plans, and rationale for prior decisions.

Meeting with the CEO alone was the first point of departure from prior, ordinarily routine, work at F&M. It soon became clear to the examiners that the bank staff was actively preventing Cletus Schmidt from meeting alone with bank examiners. This was the first inkling Eddie had that something was amiss – and one of a growing list of inconsistencies between financial and non-financial data. 

Coello also wondered aloud to Lynne that, if Cletus was indeed CEO of the bank, why didn’t he have some vision of where the bank was heading?  And why didn’t he want to share that vision with the examiners?  Ordinarily, CEO’s talk behind closed-doors with regulatory and external auditors about business plans and the like – if only to get an informed outside opinion, or at least use them as sounding-boards. Additionally, the president did not seem to have an adequate explanation of how the bank became involved with the credit appraisal company, nor the relationship between their financial analysis and eventual credit losses sustained by the bank.  Overall, though, he did not act like the CEO – neither in his actions, demeanor, knowledge, or apparent confidence.  He had a tendency, moreover, to look down and to the left either before or during his answer to even usual questioning. Rarely, in fact, did he speak without fidgeting unless his arms were tightly folded across his chest – and, unlike the other bank officers, seemed to shift his weight or gaze away more than usual while speaking with examiners. That is, unless the conversation turned to his farming interests or his family. During those times, he seemed much more relaxed and sincere – both physically and verbally. Hint: Contrary to popular notion, a substantial amount of auditors’ and examiners’ work involves interviewing and otherwise communicating with the auditees’ staff (DiGabriele, 2008). Consequently, examiners or auditors should be trained in, or familiar with, kinesic interviewing tactics.  Body language is an important non-financial form of evidence that may lead to better analysis of financial evidence.

The Loan Portfolio

The bank’s credit portfolio (including leases) was increasing by about three percent per year, in a town predominantly populated by retirees. This latter point was observed by examiners while walking around town after lunch in the local diner and discussing local demographics. Examiner Coello verified his observation by chatting with the manager of the local grocery store, where the examiners stopped (ostensibly) to purchase chewing gum. The manager disclosed that about two-thirds of his customers were Social Security recipients. A check of county demographic records substantiated his estimation. The discussion and subsequent verification left examiners wondering why relatively significant loan growth would emanate from a bank in such a community, in which one would guess that incurring debt would be limited. Consequently, Examiner Coello determined to scrutinize the bank’s loan portfolio more carefully. Hint: Understanding an audit/examination client should include an understanding of the business’ geographic, historical, economic, and cultural circumstances. Friendly discussions with local people should avoid confidential subjects, but can often be a source of non-financial information pertinent to an audit/examination.

Items written off against the loan and lease loss reserves negated about two-thirds of taxable earnings, so the effect also reduced income taxes to near zero. Most credits were either small consumer loans or relatively small commercial loans for local businesses – including car dealerships, small shops, grocers, and appliance stores. The main exception was the tanning and toning loans and leases which were all out-of-town customers. Regardless of loan purpose, J.J. boasted that (except for the one glaring mistake), his loans were generally above reproach.  Judging from the low average of past-due balances within the portfolio, he seemed to be telling the truth. Still, there were a large number of loans that, on balance, resulted in a loan/deposit (accounts receivable/customer deposits) ratio of about 75 percent. The 75 percent pushed past the rule-of-thumb in-house maximum 70 percent ratio that regulators prefer, but since asset quality was good (except for the tanning/toning loans and leases), not much notice was taken of the portfolio excess.

Physically checking collateral is not a customary part of audits/examinations. Business loans are primarily based on borrowers’ cash flow and documentary evidence of financial strength and valuation – so collateral tends to be regarded as no more than a tertiary source of repayment. To warrant physical checking of collateral, the collateral and/or circumstances would generally have to be somewhat unique (for example, expensive or giving reason for suspicion of fraud).  Since that situation is not normal, collateral reviews usually entail little more than a documentation review to ensure that banks hold legally binding liens with a sufficient (bank-determined) market value estimate.

The training focus of this examination, however, seemed to warrant physically checking collateral, especially collateral related to the tanning and toning equipment. One of the junior bank officers escorted examiners to a small warehouse where repossessed equipment was stored.  The so-called Cadillac of equipment was literally piled in the building as though it was not something of value. Indeed, it appeared to be very inexpensively made in any event. Examiners guessed (and later verified) that cost of construction would be no more than $300 – $800 per unit, compared to the bank’s retail valuation estimate of $3,000 – $8,000. Inquiries about the manufacturer, after an unusual delay, showed that the equipment had been built in, and transported from, a facility in New Jersey. Further inquiries about the manufacturer through public records indicated that the business no longer existed. Then, on a hunch, Examiner Coello telephoned the two principals (an unusual but not inappropriate tactic by an examiner or auditor). He learned that one had been imprisoned on conviction for a violent crime, and the other indicated that he planned to “disappear” –  and so should be left alone. The list of anomalies continued to grow. Hint: Examiners/auditors should understand that formal documentation can be easily forged – and so the veracity of such evidence should undergo some physical examination, at least on a sampled basis. Collateral should be examined with regard to its current value as well as the likely original value on which credit decisions were made. This provides valuable insight into the client’s evaluation processes and internal control.

Financial Analysis

A shell BHC is a BHC with few or no operations outside of holding a bank as its sole or primary asset, and the debt to purchase the bank as its primary or sole liability. Similarly, the typical BHC income statement largely showed the BHC’s primary source of income in the form of dividends from subsidiary bank and expenses in the form of interest expense on the long-term debt used to acquire the bank from its shareholders. Generally, the shell BHC would exhibit little or no net income and would frequently report small losses. Consequently, the examiners found it a relatively easy matter to audit all holding company transactions and balances. 

Notably, the income statement disclosed consulting fees and rent expenses (in and around Oklahoma City, an apartment in Dallas, and commercial office space in Fort Worth) that were unusual for a small-town BHC.  J.J. explained that the BHC wanted to expand into other tangential businesses, such as processing the billing for other service businesses and setting up a mortgage loan processing facility. To do so, he argued, the BHC had to have some presence in more populated areas. That factor, in turn, required that the BHC rent office space and, to save money, rent an apartment for housing J.J. and other bank officers while working in the area. 

Regulatory correspondence and reports filed by the bank also failed to mention any bank properties outside Gravois. Even though examiners would usually investigate only the documentation surrounding any such non-banking activity, the training nature of the exam also warranted an on-site visitation. The rented premises were found to be very nice and, notably, the office space housed a credit review facility operated by the company that F&M had hired to review leases for credit quality.  Follow-up investigations, moreover, disclosed that addresses were commonly used to route confirmations and business inquiries for several other small businesses – including a large number of tanning and toning salons.

Internal Control and Audit Function

Internal control is a system of policies, procedures, practices, and organizational structures for providing reasonable assurance that a business’s operating objectives will be achieved and that undesired events will either be prevented or detected and corrected. The internal audit function is important for an effective system of internal control because it is supposed to identify weaknesses independently, allowing management to take prompt action. 

Yet this was not the case at F&M.  J.J.’s younger son, John Jackson, was the organization’s sole internal auditor – and then only on a part-time basis. His other work included helping out wherever there was a need, generally in either the bookkeeping or loan departments. Immediately, of course, his position and work raised several well-known red flags due to his lack of training, multiple job functions, and nepotism.   

Of the few college credits that John had managed to obtain, moreover, none were in business. He eventually completed a condensed, six-week internal audit course sponsored by the Bank Administration Institute, and J.J. taught him anything else he needed to know. John’s experience was, necessarily, limited due to the nature of his part-time work in a small institution. His files, however, were admirably completed, concise, and very precise. Notably, they were also absent of any material audit exceptions. Hint: Auditors and examiners should be suspicious of internal audit reports with no, or scant, exceptions – especially in an institution which has an otherwise imperfect internal control function (Rezaee & Crumbley, 2007).

John’s familial ties also interfered with the objectivity required by industry standards, but he was not the first part-time internal auditor with split duties whom the bank had hired. Prior examinations had repeatedly identified the problem but had not resulted in punitive action due to regulatory guidance about “small banks.” Unfortunately, small-bank guidance was based on the idea that senior management in smaller institutions would generally be aware of all daily operations and transactions – and external audits were considered a check on other improprieties.  That particular guidance neither anticipated collusion with senior management, however, nor bank supervisors’ reluctance to interview external auditors in the examination process. Notably, both examiners and external auditors are often so turf conscious that they rarely interact with each other.  Since John’s and his predecessors’ recordkeeping was so meticulous, and since all of them had been so affable, their records were (unfortunately) taken at face value. The auditors and examiners had fallen into the classic trap of evaluating the person, and not the position. 

Follow-up interviews conducted with F&M’s external auditor disclosed that he, too, had relied on bank weaknesses to be mitigated by an external source – the BHC or bank examiners! Although he had audited the bank each of the previous sixteen years, the regulatory authorities had never before contacted him. Sheepishly, he also admitted never having approached bank examiners. Consequently, the external auditor not only had no mitigating evidence, but he had noted many of the same deficiencies bank examiners had reported. During one of the interviews about historical deficiencies at the bank, moreover, the auditor mentioned a similar problem “at that little business of J.J.’s.” Without arousing the auditor’s suspicion, examiners casually turned the conversation to J.J.’s “other businesses” which, according to the auditor, totaled “three or four” – none of which were theretofore reported to regulatory authorities. He could not recall all the names, but remembered that one of them was a toning and tanning salon. Hint: Examiners and auditors should approach their work more collaboratively – proactively contacting any/all other agencies that may have some historical information to share about the client – even if not required to do so. Client permission, preferably in writing, is an understandable pre-requisite, however.

Other Data Gathering

As suspicions grew over the irregularities, including the possibility of fraud, examiners looked at the files more critically than ever before. The examiners determined what specific opportunities may have been available for bank personnel to participate in banking irregularities, how those irregularities could have been concealed, and whether there were any mitigating controls that could have reduced or eliminated those opportunities. 

Without revealing their suspicions by keeping their composure, the examiners openly and critically reviewed each operational area of the bank and the BHC. With an eye towards investigating fraud, the examiners carefully considered opportunities for theft by individuals and groups that were both internal and external to the financial institution. The examiners cross listed those ideas with the potentially-affected balance sheet and/or income statement accounts. Then they considered how loan fraud might be carried out, how it could fly below the radar of auditors/examiners or be missed by auditors’ job tasks, and how audit programs could be changed to gather additional evidence if need be. They also considered external institutions that might have been involved.

Another review of public records disclosed that J.J.’s name was attached to six different business operations – and that all but one was a tanning and toning salon. Worse, a check of tanning and toning salons throughout the Midwest revealed that owners had similar business names that were somehow related to, or associated with, J.J.  Interviews with shop owners verified the links to J.J. although some owners described themselves as no more than “a friend.”

A natural follow-up led to a search of public records for the names of J.J.’s children, his daughter’s husband, and Jr.’s partner. In each case, at least one outside business was discovered, usually a tanning and toning salon. The exception was Jr.’s partner – the records showed that he was the owner/operator of the credit review business that the bank/BHC had (ostensibly) independently contracted to review loan/lease credit quality. On-site verification of the business address, moreover, indicated that the business had long-before closed. Documentation acquired during a review of that, now defunct, business disclosed the personal relationship between Jr. and his partner.  That finding, in turn, led to a broader investigation of the alleged arms-length transaction between the bank and the, now defunct, credit review business. Those findings revealed additional evidence suggesting that the bank’s personnel had actually trained the so-called credit review employees, and even paid the rent on their facilities. Increasingly, the puzzle-like pieces were taking shape.

Except for maintaining a board membership in lieu of alimony payments, J.J.’s ex-wife Liz was substantially above reproach. Additionally, she proved to be very open about discussing both bank and familial histories. A further, more detailed review of the loan portfolio (including tracing loan proceeds) also proved much more fruitful, disclosing self-interest loans, loans to friends, and loans to several other entities that were not necessarily related to J.J. but were sufficiently suspicious to warrant closer investigation. Evidence of written-off self-interest loans led to an investigation of J.J.’s clever but self-serving way of tax avoidance.

A search of prior (even old) financial statements that J.J. and other bank/BHC executive officers provided to federal regulators in previous years disclosed a few loans reported from other banks – but those loans disappeared from subsequent statements. Acting on a hunch, the examiners contacted those banks for full loan and deposit transaction histories. The records indicated loan disbursements and payments for other businesses, which were directly linked to J.J. – and so the handshake deals began to unravel. Hint: Fraud is often like a multi-layered onion, and peeling back layers leads auditors/examiners to consecutively deeper facets ever closer to the core. It is always advisable to increasingly broaden one’s analysis as evidence points toward an increasingly narrow conclusion of fraud.


Each business, loan, and relationship became part of an overall hierarchical, organizational chart-like diagram linked to J.J. Jackson. His schemes filled enough printed pages to wallpaper an entire wall in the war room of the Assistant U.S. Attorney’s office in Oklahoma City, Oklahoma.  The Assistant U.S. Attorney, understanding jury attention spans and case presentation well enough, however, pared J.J.’s crimes down to only three sheets. Those were, however, the golden bits that would ensure conviction and prison time for J.J and destroy his dynasty.

Two other F&M executive officers were convicted of knowingly facilitating J.J.’s schemes: the Executive Vice President in charge of operations and the Vice President in charge of lending (J.J.’s first and second cousins, respectively). Cletus Schmidt, the bank’s president, was not prosecuted, mainly because he seemed to be a hapless pawn in the operation and was largely ignorant of and apparently unable to comprehend the extent or complexity of J.J.’s fraudulent schemes. He was forced to take an early retirement from the bank at the age of 64, however, and live on a modest pension. After the ordeal, he was quoted as saying, “Good.  Now I can go back to church and be done with those rascals.” John Jackson was also prosecuted, but received an extended probation in lieu of jail time. He also lost his job and was banned from banking for life. Similarly, the other relatives and all but the most essential operational staff lost their jobs. Their lack of credible references also effectively banned them from banking for life. J.J. was forced to sell his interests in the bank/BHC, which were promptly purchased by board member Dr. Clinton Ferris, who immediately brought in an outside CEO and worked with him to re-staff the bank. He subsequently placed his bank ownership in a blind trust and retired to California, purchasing a home very near Liz Jackson’s condominium.

Lynne Kupcinet became a commissioned bank examiner almost exactly three years from her date of hire, and transferred to the Board of Governors in Washington, D.C.  Subsequently, she became a valuable assistant in the Office of Inspector General. After marrying a community lawyer, however, the couple left D.C. for a horse farm in Montana – where they have been raising their five children since that time.

Eddie Coello remained a senior bank examiner, specializing in forensic accounting and fraud examination for the Federal Reserve System.


Eddie Herron

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.   


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DiGabriele, J. A. (2008). An empirical investigation of the relevant skills of forensic accountants. Journal of Education for Business, 83, 331-338.

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.

DiGabriele, J. A. (2011). Revisiting the integration of forensic accounting and the auditing paradigm. The Forensic Examiner, 20:2, 70-73.

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.

Rezaee, Z., Crumbley, D. L. & Elmore, R.C. (2005). Forensic accounting education: A survey of academicians and practitioners. Advances in Accounting Teaching and Curriculum Innovations. Nov. 6, 2005, 39-43.

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.


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