Investigating Your Own Company

When business owners suspect wrongdoing within the company, the probe should be a partnership of their attorney and CPA

Andrew D. Pappas, CPA

The interrelationship of the services offered to a business by attorneys and certified public accountants is a subject of ongoing interest, particularly as it pertains to “multidisciplinary practices” uniting lawyers and other professionals, such as accountants. One area in which a business executive may turn to either an attorney or a CPA, or both, is the internal corporate investigation.

See: Warning Signs of Potential Employee Theft or Fraud and Some Common Methods of Fraud

Red Flags. An internal-investigation scenario typically begins when a business owner or manager first notices symptoms of trouble and change in the customary rhythm and results of operations. These results may include erratic cash flow, reduction in gross profit margins (profit leakage), an increase in the cost of goods sold, inventory shrinkage, eroding market share, deterioration of plant or facilities, or late payment of bills. Sometimes, rather than spotting overt symptoms, the owner or manager simply has a “gut feeling” that things are not quite right with the business.

An experienced financial investigator is also called for in due diligence situations, whether a prospective acquisition or a large loan transaction. In neither case should the subject’s financial statements – even when prepared by a top accounting firm – or its contractual warranties, be accepted at face value.

Just as the toothache demands a dentist, or the malfunctioning car a professional mechanic, the business owner in this circumstance would be wise to call in a professional to find the root of the problem and prescribe a cure. The “pro” can be a lawyer or a CPA with practical business, financial or operational investigatory experience.

Protection. In many cases, the company’s in-house lawyer or outside counsel should officially retain the outside investigator, in order to extend the lawyer-client privilege to the investigator’s interviews, notes and work product. This may protect these items from discovery and use by adverse parties in legal proceedings.

Ground Rules. The investigator’s initial interview of the client covers many bases and establishes the ground rules for the inquiry:

• Does the investigator have complete freedom and his or her client’s complete support for all investigatory activities, wherever they might lead?

• Are there any areas that are out of bounds?

• Does the client have a pre-conceived conclusion that he or she just wishes to have proved?

The good investigator insists on complete freedom, but can live with a client’s prejudgment, if it can be verified by solid findings. In fact, the investigator should ask the client to state what he or she thinks is going on, his or her suspicions as to the cause of the problem.

Investigative Process. The savvy investigator begins by learning and assessing the environment in which he or she will operate, conducting inventories of merchandise or equipment, reconciling bank accounts and accounts receivable, perhaps even performing cash counts. The investigator will tour the client’s factory, view the machinery and equipment, note the state of repair and the relative modernity of the physical surroundings, observe the production systems and processes, talk to employees on the floor, visit the offices, and interview selected personnel.

To his or her physical observations, the investigator will add an analysis of internal controls and perception of management’s style and the attendant work atmosphere and employee attitudes. The investigator also examines key company documents (plant and equipment leases, sales and supply contracts, commission agreements, employee contracts, financing agreements, insurance policies, etc.). He or she often seeks a lawyer’s backup on this. The investigator will read and compare financial statements over a period of years and fractions of years, which often can lead to isolating symptoms and tying them to likely causes. The company’s bank statements and other indicia of cash flow and cash management are equally important to review.

This process, together with the information – fact, suspicion, and the rest – supplied by the client, invariably flags areas warranting further investigation. Tentative hypotheses suggest themselves, and the investigator prioritizes them in order of probability, often noting that several schemes or control failures might be operating synergistically or in a complementary fashion.

The investigator requisitions more documents and conducts further interviews with people involved in the targeted areas. Here the investigator must tread lightly, proceeding under the direct authority of the client, working with the client’s trusted lieutenants to mask – if necessary – the true purpose of the inquiry. With additional financial records in hand, the investigator can pinpoint the origin of profit leakage.

Diagnosis. Now a fairly firm preliminary diagnosis can be made, preferably in an oral report to the client and his or her lawyer. The investigator will tentatively identify the apparent roots of the problem, and perhaps be able to name the likely miscreants. He or she might recommend a few areas to be further probed, people to be questioned, perhaps confronted. The investigator often taps the expertise of specialized consultants knowledgeable in, for example, insurance or technology.

Further inquiries run a high risk of alerting the guilty, risking destruction of evidence. The quest for actionable proof requires a delicate touch. And if dishonesty is indicated, rather than simply negligent control or procedural failures, the client’s often intense desire to confront the “traitors” immediately must be restrained.

Catching the Culprit. Working with the client’s legal counsel, the investigator’s clinching procedures may include a “sting” operation designed to catch the culprit in the act, or inventorying merchandise and equipment, reconciling cash or receivable accounts, securing copies of incriminating checks or purchase orders, performing cash counts, even personally distributing payroll checks.

Final Report. A final report to the client, with supportive evidence commensurate with the level of investigatory depth authorized, recommendations for ending the existing problem, and suggestions of structural changes needed to prevent recurrence, is the ultimate “product.” Here again, the company’s lawyer must vet and approve anything that identifies or indelibly points to the responsible parties.

There are more variables to investigatory subjects, and the procedures needed to pursue them, than can be covered in a general-purpose article. Nevertheless, the foregoing can serve as a primer for the internal corporate investigation.

Warning Signs of Potential Employee Theft or Fraud

Key employees never take holidays or vacation time, out of fear of their fraud being detected during their absence

Your accounting department starts experiencing an unusually large number of write-offs for bad debts

A puzzling trend has surfaced among invoices, revealing changes, substitutions and partial deliveries

Review procedures for payment of invoices include only the employee who prepared the checks

Discrepancies have emerged between physical inventory count and inventory records

Slow collections can be a mask to hide employee theft

Changes in an employee’s behavior, such as becoming withdrawn, anxious or distrustful

Unexplained employee wealth or living beyond apparent means

Customer complaints of missing statements and unrecognized transactions

Cozy relationships with suppliers or contractors

Key employees having too much control or authority without audit checks

Some Common Methods of Fraud

Misappropriation of cash

Inventory theft

Inflated invoices for sales

Inflated invoices for purchases

Non-delivery or short-shipping of purchases

On-premises consumption of inventory and supplies

Third-party pilferage

Fictitious payouts for returned goods

Company payment of employee bills

Payments to bogus vendors

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