Bulldog gets the worm: In a case of missing inventory, persistence, vigilance, and a little luck pay off big - Fraud Findings

Internal Auditor, Dec, 2001 by Courtenay Thompson

YZ COMPANY'S AUDIT manager, Mark Wright, was troubled. Something didn't sit quite right with a recent investigation. If he was to believe the initial "facts," the manager of one of the organization's business units was a weak link, but Mark suspected this was not the case.

Mark's internal audit department and the company's security team had jointly investigated the disappearance of more than $2 million of the company's raw materials that had been sent to a third-party processor. Although the processor was billed for the loss, the plant declared bankruptcy shortly thereafter, leaving Mark's company with a $2.1 million write-off. Based upon the initial information, it looked as though the processor had duped the manager of the business unit out of the raw materials. But a second look started Mark down a trail that would eventually lead to Mexico.

BACKGROUND

The manager of XYZ's business unit told Mark that he had committed to sending excess quantities of raw material to the processing plant to help the plant owner obtain financing. Although this arrangement would also benefit XYZ, the manager said that he did not anticipate the large buildup of excess quantity. But the plant owner did, and as soon as he realized the amount he had accumulated, he reduced his bank-loan request and opportunistically began using XYZ's inventory for other clients. When XYZ was ready to use the material, it was not there, and the processor couldn't afford to buy more. Eventually, this led to the bankruptcy filing and the "$2.1 million bag," as Mark referred to it.

At that point, the evidence suggested that the processor had committed fraud against XYZ and the XYZ manager was incompetent, but relatively innocent. However, the incident continued to trouble Mark. He knew that the manager was anything but stupid and that he was not prone to random acts of kindness. But what made Mark raise an eyebrow was that approximately a year after the processing plant's bankruptcy, the business unit manager left XYZ Co. to start his own business, in direct competition with XYZ.

During an unrelated investigation, Mark had the opportunity to question one of the business unit manager's coworkers on what he knew about the missing inventory at the processing plant. Although the individual claimed to know nothing firsthand, he said he had heard that the missing inventory was styrene monomer an suggested that Mark check into that commodity.

Much to Mark's surprise, he found that a year-long shortage of styrene monomer had caused the plastic's spot price to be considerably higher than the supply-contract price. In Mexico, for example, the spot rice shot up to $1.20 per pound for styrene monomer that had been 60 cents per pound in the United States under supply contracts. Consequently, supply contracts were only partially honored For example, a purchaser might receive only 90 percent of what he originally contracted for, and he'd get that only if he agreed not to resell any of the product he was sent.

The picture was becoming clearer for Mark. The styrene monomer that had gone to the processor had been acquired at an average price of 62 cents per pound. In fact, 62 cents was the price that XYZ used to bill the plant owner for the missing inventory. The plant owner, however, was reselling the plastic for about $1.20, a price that enabled him to make a significant profit.

THE INVESTIGATION

With the pricing information in hand, Mark then focused on the process used to schedule the purchases and ship them to the processor. An employee from the Purchasing Department told Mark that the business unit manager had been approached about the excess buildup and his only reply was to "just keep it coming." In addition, the purchasing employee had tried to determine what products were being sold and was told that it was not his concern. Further, another employee tried to visit the processing plant to determine how much XXZ inventory was on hand, but his trip was cancelled by the manager.

The purchasing employee also remembered that, during the time of the inventory buildup, the supply scheduler from the plant's supply and distribution function seemed to be dropping hints that something was not quite right. Mark decided to contact him. Because the plant was shut down and the supply scheduler was out of work, there was no motivation for him to hide the truth. Unfortunately, the supply scheduler only had one piece of the puzzle.

He told Mark that all of the quantities that the plant received from its major suppliers were received under allocation. Instead of processing the styrene monomer into a finished product, however, the quantities were shipped out to the Midwest plants of Chaseman, a major producer. One curiose tidbit that the scheduler pointed out was that the plant never bought from Chaseman; it only shipped to Chaseman. And, to Mark's bewilderment, the shipments sent to Chaseman were sold for the same amount that the plant paid to purchase the incoming material.

Given the normal selling, general, and administrative expenses, the plant was steadily losing money; thus the eventual bankruptcy. When XYZ's quantities were received for processing, they just became part of the steady stream transferred to the Chaseman plants. That's why none of the XYZ material was processed into finished goods and why there was no inventory on hand.