Fraud and the Perils of Absentee Ownership

While fraud is a threat even for a hands-on owner, a recent engagement showed how absentee owners are especially susceptible … and what they can do to reduce their risk

Andrew D. Pappas, CPA

In comparison to business and property owners who are actively engaged in their enterprises and maintain at least a part-time presence, absentee owners expose themselves to additional risks of fraud, mismanagement and embezzlement. The further threats can come not only from suppliers, vendors and rank-and-file employees but, also, and perhaps more important, from the managers and executives they hire to run the enterprise in their absence.

Background. Malfeasance at the management level recently threatened the financial health of the owners of a large apartment complex. The owners, all absentee and most living out of state, had contracted with a property management company to handle all matters for the complex. This company also managed several other properties.

Within the scope of its services, the property management company engaged a CPA firm to provide accounting, bookkeeping and other professional services for the complex. After reviewing the management company’s financial procedures, reporting and internal controls, the CPA firm gave a positive report to the management company and to the apartment complex ownership group. What the CPA firm and the management company did not report to the ownership group was that the CPA firm also performed services for about half of the other properties under the management company’s care and for the management company’s owner.

In short, the management company’s owner hired his personal CPA firm to review the management practices and procedures that he employed on behalf of his clients. Had the apartment complex’s owners known about the relationship, the potential for conflicts of interest and disservice to them would have been obvious.

Gradually, the complex’s cash flow began to suffer, even though occupancy and other factors remained steady. The cash situation deteriorated to the point that one of the members of the ownership group, a client of our firm, engaged us to perform an independent forensic examination of the apartment complex’s management and financial situation.

What We Found. In the role and with the mindset described in the sidebar below (“Conventional vs. Forensic CPAs”), we performed a forensic examination that uncovered a variety of schemes that the management company had used to benefit itself at the expense of the apartment complex’s owners.

Conventional vs. Forensic CPAs: There are significant differences between a conventional audit and a forensic examination. A conventional CPA generally takes an independent look at procedures, controls and records and, based on a sampling of various transactions, issues a report. In many cases, this approach is adequate; in others, it is not. In contrast to a conventional CPA audit, a forensic accountant approaches his examination not from a position of neutrality but of advocacy. He should be guided by the question, “How would a person with an evil mind or corrupt intent exploit this situation?”

The dishonest practices included the following:

• Self-dealing by the property manager. The management contract barred the management company from performing repairs and maintenance. To get around that prohibition, the management company’s owner created another company to provide those services for the complex and arranged for his management company to contract with his maintenance company. That cozy relationship was not disclosed to the apartment complex’s owners. The maintenance company proceeded to overcharge for its services, performed services that were unnecessary, and issued phony bids and bogus invoices.

• Stolen funds from the complex. The management company retained for itself half of the reduction in property taxes that it had negotiated for the building. That practice was also prohibited under the terms of the management contract.

• Use of complex funds for its own gain. The management company used the rents that it collected for its own purposes before depositing them in the owner’s account. This was another contractually prohibited practice.

• Fake appraisal of the complex. The management company provided the owners of the complex with a real estate appraisal showing that the property was worth half of its actual market value. The bogus appraisal was intended to allow another entity related to the property management company to purchase the complex at a sharply discounted price.

• Use of complex funds to pay company expenses. The management company also ran some of its expenses though the apartment complex’s books. Improper expenditures included the management company’s Christmas party and legal and personnel costs unrelated to the complex.

What’s an Owner to Do? Even absentee owners can employ measures to lessen the likelihood of fraud, mismanagement and embezzlement. Safeguards include the following:

• Reserve and exercise the right to hire all professional service providers (attorneys, CPAs, etc.) and approve all third-party vendors.

• Retain ultimate power of making major decisions. The management company may give input to the owners, but the owners must give the final approval.

• Utilize the investigative services of a forensic accountant. In cases such as this, one of the key considerations is not what is in the books and records, but what isn’t. This requires the expertise of a forensic accountant who can think with an “evil mind.”

• Let the management company know in advance that there will be periodic reviews by the forensic accountant.

• The owners, together with their legal counsel and the forensic accountant, should develop and strictly enforce clearly defined approaches and procedures and give the forensic accountant discretion to modify or expand the procedures as appropriate.

To limit the forensic accountant’s powers and keep costs in check, the owners should consult with him about the frequency of his services. It is the responsibility of the forensic accountant to explain the value of his services and the potential cost to the owner if a scheme of the management company is not detected and resolved.

While the preceding account is based on an actual case, the facts have been simplified and the names of all parties have been changed.

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