HOW THE FRAUDSTERS FOOL THE AUDITORS
Perpetrators use a variety of concealment techniques to hide their wrongdoing from
auditors and others who examine the books and records. This session highlights the
techniques used to commit financial statement fraud and therefore demonstrates why auditors
are not able to detect the fraud. Using real-life case studies, this session will also look at the
chronology of events that can lead to an auditor negligence case and will discuss the red flags
that auditors often overlook.
ANGELA CLANCY, CA
Senior Manager
PPB Advisory
Australia
Angela Clancy has more than seven years of international experience in investigative
accounting. Throughout her career she has utilised electronic data analysis to effectively
accomplish accounting investigations and asset recoveries. She has also been responsible for
the development of training programs to assist in the application of investigative data
management techniques. Her experience has seen her involved in various fraud-related
schemes including mortgage fraud, vendor fraud, and kickback schemes.
“Association of Certified Fraud Examiners,” “Certified Fraud Examiner,” “CFE,” “ACFE,” and the
ACFE Logo are trademarks owned by the Association of Certified Fraud Examiners, Inc. The contents of
this paper may not be transmitted, re-published, modified, reproduced, distributed, copied, or sold without
the prior consent of the author.
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HOW THE FRAUDSTERS FOOL THE AUDITORS
In the last ten years large corporate collapses and scandals
occurring in United States and Australia have resulted in a
significant scale of regulation to combat problems
surrounding auditor independence and financial statement
fraud.
Regardless of the regulation, auditor negligence cases
involving financial statement fraud continue to occur. This
paper explores the issues that auditors face and the
circumstances that lead to financial frauds being missed by
auditors—and in some cases how the auditors become a
part of the fraud being perpetrated.
Paramount to auditors maintaining their professional
skeptical is the ability to be independent. Without
professional skepticism, the auditor is in no position to be
able to identify fraud. The ACFE’s 2012 Report to the
Nations found that external auditors were responsible for
initially detecting 3.3 percent of occupational frauds. This
is an alarmingly low statistic given that the external
auditors are in the best position to detect fraud.
The key aspects for a quality audit are that the auditor
collects sufficient, competent, and reliable evidence, and
that relevant issues have been reported appropriately.1
Accordingly, to establish an auditor negligence case
identifying the quality of evidence collected by the auditor
and the issues reported are critical. Issues that affect the
auditor’s inability to provide these deliverables include:
Dependence on fees
 Lack of fees to perform an adequate audit

1
Friendly relationships that are developed over time
between the auditors and management
Regulations of Auditors, John Wiley and Sons Australia, Ltd, page 1.
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
Lack of independence
 Conflicts of interest
 Sophistication of the fraud
 An audit partner relying too heavily on junior staff to
identify and report the issues
Two case studies are discussed below which highlight the
role the auditor played in providing an unqualified opinion
when financial statements fraud existed.
Case Study:
Improper Acquisition Accounting and Coopting of
Auditors
The Players
Bill “Papa” Thomas was the warehouse manager for
Jenkins Manufacturing in Lubbock, Texas. He was a
native Texan and a straight shooter who had worked at
Jenkins for more than 30 years. Jenkins Manufacturing
had recently been acquired by a large multinational
conglomerate, Yellowstar Industries, and Papa was
being asked to perform write-downs of inventory that
far exceeded anything he'd done in the past. He didn't
understand why these write-downs were necessary. But
ultimately Papa didn't want to disappoint his new
bosses. He and other Jenkins execs were being granted
stock options in Yellowstar as part of the acquisition
and he wanted to cash out and retire. Papa did what
they asked him to do. Papa was a puppet.
Karen Jillwater (Jill) was under a lot of pressure. She
was a senior accounting manager at Hope Electronics in
Annapolis, Maryland. She was stressed out that her new
bosses at Yellowstar Industries, which had just acquired
Hope, had a different way of doing things. The outside
accountants were specifically directing Jill to defer
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revenue on some recent shipments, which she didn't
understand. The shipments had gone out and had
already been received by the customer. But in the end
Jill didn’t want to raise a ruckus with Yellowstar’s
managers—or call into question the judgment of the
outside auditing firm. She reasoned that Yellowstar was
a public company, with big firm auditors, so they must
know what they’re doing. Jill was a puppet.
The puppet master’s name was Maxwell Cruz, the CFO
of Yellowstar. He was more commonly known as
“Crucut” given his legendary prowess in cutting costs.
Crucut was an intense number cruncher, a difficult man,
and a brutal manager. He expected unwavering
obedience to his instructions. You didn’t want to mess
with Crucut Cruz. He’d take your head off. A former
auditor at the same firm currently serving as
Yellowstar’s outside auditor, Cruz was now the righthand man to Shelby McGinnis, the larger-than-life CEO
at Yellowstar. McGinnis was obsessed with growth and
keeping Yellowstar’s stock price high. Together,
McGinnis and Cruz cooked up an aggressive expansion
plan that relied on acquisitions to rapidly grow
Yellowstar and boost earnings. Cruz also implemented
some new and creative accounting techniques that made
all the difference for Yellowstar—and more
important—he convinced Yellowstar’s outside auditor
to come along for the ride, helping to account for the
acquisitions as they occurred and, of course, issuing
their annual seal of approval for Yellowstar’s
financials.
Five years later, McGinnis, Cruz, and Yellowstar were
on a roll. Wall Street was praising McGinnis for
delivering results, which he thoroughly enjoyed, and
the stock was soaring. Cruz, meanwhile, had become
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the full-fledged puppet master. Both men were sitting
on a pile of money generated from their Yellowstar
stock holdings. In each new acquisition, Cruz led a
team of accountants and auditors from his old firm in
performing surgery on the books of the acquired
companies and heading up the integrations. They cut
costs savagely. They also changed the way the
accounting was handled at the acquired firms in some
creative ways. Sure, they got some resistance along the
way, but as Cruz reasoned and McGinnis supported,
these people worked for him and they better damn well
do as he directed. And one way or another, they usually
did.
That is, until a whistleblower lawsuit came to light
alleging that improper acquisition accounting had been
employed to boost earnings and artificially inflate the
stock price. When news of the scheme started to leak,
the stock price plummeted and we were retained to
investigate these allegations.
A National Investigation
From the start, we suspected that the accounting for the
acquisitions might involve various financial statement
fraud schemes, principally premature recognition of
expenses, delays in revenue recognition, and
reserve/inventory manipulation. These schemes, we
believed, were employed by Yellowstar to cook the
books of the acquired company during the acquisition
period, making it look unprofitable. Then, after the
acquisition was completed, the same entries would be
reversed in order to spring load (improve) the financial
results of Yellowstar in the consolidated financial
statements.
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The investigation initially included financial statement
analysis and document reviews, but extensive
interviews and in-person meetings with witnesses
became our primary focus as the case progressed. We
were hoping to flesh out details with witnesses as to
how the schemes worked, who was calling the shots
and how high up the chain of command the fraud
extended. We also wanted to determine how
Yellowstar’s accountants missed this scheme for all
these years. On our list of interview targets were
personnel from Jenkins Manufacturing in Lubbock,
Texas, and Hope Electronics in Annapolis, Maryland.
We met Papa Thomas at Wild Bill’s Fried Chicken
House in Idalou, Texas, where he lived, just northeast
of Lubbock, off highway 82. Papa described how
Crucut Cruz and his minions had dictated various
inventory write-offs that seemed nonsensical. “It didn’t
make a damn lick of sense to me at the time,” he
explained, “but I figured those new cats from
Yellowstar are calling the shots now, so I better do
what they say.” But when Yellowstar’s accountants
later reversed those same write-offs, after the financial
statements were fully consolidated, Papa was livid and
wanted some answers. “At that point, I just figured they
were either stupid or couldn’t make up their minds. I
never figured it was part of a grand plan … that is, till I
started poking around some more,” said Papa.
After Papa started asking some questions, one of the
accountants at Jenkins told him exactly what was going
on—by reversing the inventory write-off, Yellowstar
was making their income statement look better in the
current quarter. The Jenkins’s accountant told Papa that
it was all just a big earnings game and that was how
Crucut Cruz wanted it done. He also shared with Papa
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that he heard through the grapevine that Yellowstar did
this sort of thing with all of their acquisitions. That’s
when it really dawned on Papa that Cruz was cooking
the books. He explained, “I thought, holy shit, these
guys aren’t stupid, they’re crooks.” Papa stuck around
for a few months to get his severance, and then he “got
the hell out of dodge.” Papa didn’t like being a puppet.
A few weeks later we were sitting in a Denny’s in
Highland Beach, Maryland, just south of Annapolis
where Karen Jillwater described the details of her
experiences at Hope Electronics—both before and after
the company was acquired by Yellowstar. It was clear
from our conversation that she was a top-notch
accountant. Before working at Hope, Jill was a Big
Four accountant, so she’d been an external auditor and
she knew what the auditors should be doing. Jill was
appalled by what she saw at Yellowstar and it was
important for her to set the record straight. “I knew
something wasn’t right with what Cruz and those
Yellowstar auditors were telling me to do,” she said.
After some encouragement, Jill described in detail a
number of entries that Yellowstar and its external
auditors (Crucut’s old firm) pushed through at Hope
during the acquisition period. In addition to holding
back on revenue recognition when shipments were
already made, Jill said that Crucut and his team prepaid
a number of expenses and ran them right through the
current period’s income statement. She thought this was
crazy at the time, explaining, “When I went to Cruz and
told him those expenses should be booked as a prepaid
asset, not a current period expense, he told me to shut
the hell up and do as I was told. What a nasty man he
was.” But when she saw how good the financial
statements looked after the acquisition, it dawned on
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her what the method to Cruz’s madness was. Post
consolidation, the revenue figures were up (because the
revenue held back on shipments was now recorded) and
the expense figures were down (because many expenses
had been prepaid and recognized), so the earnings
figures for Yellowstar were fantastic.
We heard countless stories like Papa’s and Jill’s from
other witnesses across the country, which really helped
build the case. What Jill, Papa, and the others didn't
realize at the time was that there was a much larger
financial statement fraud being perpetrated by
Yellowstar and suborned by their outside auditors.
Once McGinnis and Cruz came to terms with all of the
acquired companies, they quickly brought in their hired
guns (the same accounting firm handling Yellowstar’s
audit), who were generating millions in fees, then they
took over the accounting and starting cooking the books
in every acquisition. They'd been doing this for years,
in hundreds of acquisitions, and they knew just how to
go about it. But it was only a matter of time until the
truth came to light.
The Final Cut
Our investigation in this case consisted of a number of
steps, including document reviews, financial statement
analysis, as well as extensive research and, most
important, detailed interviews of witnesses across the
country. Overall we identified and interviewed several
key witnesses who provided detailed information and
documents supporting the spring-loading allegations in
several acquisitions.
The litigation carried on for quite some time, but
ultimately the witness statements were crucial in
establishing that financial statement fraud had in fact
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taken place—and that it was directed by senior
Yellowstar management and blessed by their outside
accountants. Our interviews also helped the attorneys in
the case negotiate a settlement against Yellowstar and
their accounting firm on behalf of Yellowstar’s
investors. More than $1 billion in damages was
ultimately awarded in the resolution of the investor suit.
Meanwhile Shelby McGinnis and Crucut Cruz were
unceremoniously dumped from the company and began
fending off SEC and DOJ probes into their actions at
Yellowstar. Ultimately both were convicted of fraud
and served prison time. The outside accountants settled
the civil lawsuit, suffered no criminal repercussions,
and lived to bill another day.
Lesson Learned—Coopting of Auditors
This fraud was made possible, in part, because the
internal and external auditors who were supposed to
serve as the gatekeepers at Yellowstar were actually
coopted by crooked company executives. Cruz knew
that he didn’t need to deceive the internal and external
auditors; he just needed to get them onboard with his
scheme. So he gave them a powerful incentive to do
what he wanted. For the internal auditors, that incentive
was large stock option awards. The internal auditors
wanted the stock to keep going up as much as
McGinnis and Cruz did, so they would be rewarded
through the increase in Yellowstar’s stock price. As for
the external auditors, McGinnis and Cruz’s strategy
didn’t raise any red flags with them because
Yellowstar’s prodigious acquisitions created a huge
amount of work for the external audit firm.
Additionally, Cruz was previously employed by the
same firm doing Yellowstar’s audits, so he knew which
partners to employ and what buttons to push. The
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external auditors knew where their bread was buttered
so they went along with the scheme.
Case Study: Loan Fraud and a Questionable Audit
The Trigger Point
Billy headed up the anti-money laundering team at
Southgate Bank. He was responsible for identifying and
reporting suspicious transactions, as required by the
regulatory bodies overseeing banks.
On Wednesday evening as Billy was about to head to
the local pub for the weekly trivia night, he came across
an unusual transaction involving a company named
Aussie Auto Loans (AAL). On the second glance he
recalled that his friend Trevor was the relationship
manager for AAL, and AAL was one of Trevor’s key
clients.
AAL sourced car loans from brokers who had
relationships with all the dealers. AAL then collated the
paperwork and provided the money to the borrowers.
AAL funded its business through finance from
Southgate Bank. In turn, the bank sought security over
the loans and also made a company connected to AAL
guarantee payment if the loans became delinquent.
When Trevor first received their business, he thought it
was a pretty sweet deal for the bank. Just to be sure that
it was a low-risk exposure for Southgate, Trevor
required a regular audit to be performed by an external
accounting firm. Billy remembered that last week in the
break room Trevor was expressing his annoyance with
AAL for falling behind in payments.
The unusual transaction just didn’t make any sense, so
Billy dug a little deeper into the transaction flow and
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found a significant amount of money being transferred
to a bank account with the name Illusion Licenses Pty
Ltd. Something didn’t seem right with this transaction.
Billy was keen to get to trivia but he knew this should
be brought to Trevor’s attention immediately. Billy
emailed the details of the transaction to Trevor.
The next morning, Billy arrived a little late to work
after having a few beers in celebration of his victory in
trivia. A meeting was being held concerning his
findings on AAL, to which Billy dashed off. As the
discussion progressed, it was discovered that the money
should have been paid to one of AAL’s brokers.
Illusion Licenses Pty Ltd did not sound like the name of
a broker.
More Red Flags
Southgate managers wanted to have someone perform
an audit of AAL immediately in the hopes of putting
everyone at ease. Trevor was reluctant to use the
current auditors because they were not from a big name
firm and he was not aware of their reputation. It was a
suburban audit company that the directors of AAL had
chosen, and Trevor was concerned that they missed this
problem in the first place. Feeling quite uneasy, Trevor
made a call to one of the Big Four firms to see if they
could perform an immediate audit of the outstanding
loans.
The newly appointed auditor called AAL management
and told them that she would be conducting an audit the
next day. The auditor was awakened in the morning by
a call from one of the directors of AAL, informing her
that they had a power failure and she would not be able
to visit the premises that day.
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When Trevor became aware of this, he immediately
made calls to AAL with no answer. He called each of
the directors and again, his calls were unanswered. The
case was developing a high profile and everyone at
Southgate was getting very nervous about what was
going on at AAL.
Appointing an Investigator
Meanwhile, at the offices of MMQ, Charlie was
wrapping up a meeting with creditors. Charlie was an
official liquidator and had a reputation for being fair but
hard. He was delighted to inform them that they would
be receiving 70 cents on the dollar, and the creditors
were pleased with Charlie’s accomplishment. He loved
to go after every penny and was very good at it.
Trevor had worked with MMQ and Charlie in the past
and placed an immediate call to him to see if he could
help sort out the problem with AAL.
Charlie arrived at the AAL premises at 2:03 p.m. The
lights were out and it didn’t look like anyone was in the
building. By 7:00 p.m., Southgate managed to appoint
two partners at MMQ as the receivers and managers
and Charlie was allowed to enter the premises. He
called a locksmith and was inside by 7:33 p.m.
Charlie entered the premises and discovered an office
without computers or laptops. Cables lay in places
where the computers should have been and there were
laptop hubs but no laptops in sight. Some of the books
and records were still there, but it looked like a number
of the file cabinets had been ransacked. Knowing that it
would be difficult to keep the business going without
computers, Charlie performed a search for the servers.
At least with the servers Charlie was confident they
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would be able to recover the records and get the
business up and going. The room with the servers
looked a little empty for Charlie's liking. This situation
was a first for Charlie and he knew he needed some
help from the MMQ forensics team.
Let the Investigation Begin
Charlie called Southgate to see if they had a list of
outstanding loans at AAL, but unfortunately Trevor did
not maintain one. Without records of who owed each
loan, there would be nothing for Charlie to recover—a
thought that he did not appreciate.
The next day the forensic technology team was on-site
attempting to figure out how to recover the electronic
data. They found that the backup tapes were located
off-site, which came as a relief, and they had them
immediately couriered. There was one big problem,
though—the tapes were blank.
I am not sure if it was Charlie’s lucky day, but within
48 hours the forensic team located a copy of the loan
database.
AAL used a third-party licensed software system to
maintain their loan database. After a call to the software
provider, it was green lights for the team. The software
provider had built into the program an automatic
monthly backup function. Each month the loan database
was backed up to a file server located in Pakistan! After
finding this out, the database was successfully
retrieved.
There was one more hiccup for the MMQ team; the
loan database was about a month old. Further inquiries
led the team to discover that all the company’s emails
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were stored on an email server that had remained onsite. The emails contained correspondence to and from
staff and clients up to and including the day that MMQ
was appointed as receiver and manager, detailing
various loan transactions.
Together with the emails received over the last month,
paper files and the contents of the loan database, a team
of MMQ analysts were able to piece together an up-todate database of all the outstanding loans. But the
puzzle remained incomplete. Was there fraud? Where
was it? Why were the business records missing?
Unraveling the Rest of the Investigation
MMQ analysts matched each loan file, related
documents and emails against the loan book. Quickly it
became evident that the loans made on behalf of a
broker called Irish International were a work of fiction.
The total outstanding loans to Irish International
amounted to $20 million.
It became evident that all the directors at AAL were
involved. Each of them worked in the day-to-day
operations of the business and had been responsible for
sourcing and approving Irish International loans. An
analysis of the bank statement activity identified that
when the money for Irish International was received it
was siphoned off to director-related bank accounts, one
of which included Illusion Licenses. To keep the
scheme from being detected they would source new
loans so that they could make the monthly loan
payments to ensure that the fraudulent loans did not
become delinquent.
Interviews of employees revealed a common theme: “I
don’t know anything about Irish International,” “The
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directors handled that account,” “Those transactions
always seemed quite strange,” and “When the auditors
visited they only spoke to the three directors.”
Fooling the Auditors
Trevor and Charlie met to discuss the investigation and
Trevor said the one thing everyone at Southgate wanted
to know was how the auditors didn’t find the fraud. The
MMQ team ploughed through the audit work papers,
emails, and documents in an attempt to figure out an
answer to Trevor’s question. It was obvious that the
audit partner had spent a limited amount of time
working on the file.
And then, bingo! It became clear through emails that
the auditors received a file of all the outstanding loans
prior to the on-site visit for the audit. The auditors
would select the loans they wanted to review of the
documentation and then give the AAL directors
advance warning. An unsuspecting auditor would visit
the AAL offices after the directors had time to concoct
a thick loan file full of forged documentation.
There was one more thing that bothered Charlie. The
bank had received a guarantee from Aussie Auto Care
(AAC) in case the loans defaulted. The auditors were
aware of this situation and it appeared they asked the
AAL directors to sign on a confirmation. Two problems
arose from this.
First, the directors of AAC were also the directors of
AAL.
Second, AAC’s only source of revenue was from AAL;
without AAL, AAC failed to be able to even operate.
This issue had not been communicated to anyone at
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Southgate, and after reviewing the case file, Southgate
executives decided to sue the auditors for negligence.
The auditors and Southgate came to an agreement
outside of court, and the details are confidential.
Lesson Learned
One of the key lessons to be learned from this case was
that just because fraud is involved, the auditors are not
necessarily entirely to blame. An auditor negligence
case requires careful examination of the work papers
and identification as to whether the auditor failed to
comply with the audit standards. In this case there were
instances where the auditor relied upon fraudulent
documents and representations from management, but it
appeared that they had complied with the audit
standards.
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