Dissecting a complex trade-skill education program case, part 1


By Joseph R. Dervaes, CFE, CIA, ACFE Fellow
joseph-dervaes-80x80.jpg   Fraud's Finer Points: Case history applications

 MarchApril-trade-school-fraudster    
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Hundreds of taxpayer-supported public high schools and colleges offer trade-skill education programs that enable many to pursue lifelong technical careers. These programs are designed to break even over a period of time, but the most efficient and effective programs actually generate some income.

Accountability for program funds is always an important issue; however, the primary purpose of these programs is to educate students in trade skills and prepare them for careers after graduation.

SKIMMING IS THE FRAUD OF CHOICE

As we discussed in the January/February 2013 column, employee fraud and abuse in these programs is usually a case of simple asset misappropriation. In the ACFE’s Fraud Tree, the cash schemes (part of asset misappropriations), which involves stealing of an entity’s funds, falls into three categories: larceny, fraudulent disbursements and skimming. Cash larceny schemes involve the theft of funds recorded in the entity’s accounting records, and skimming is the theft of off-book funds. In fraudulent disbursement schemes, an employee makes a distribution of company funds for a dishonest purpose.

Our discussion in this two-part series will focus on the most complex skimming fraud case study I ever encountered. The case, which dealt with trade-skill education programs, unfolded over four years at one of the largest technical colleges in the state of Washington.

CASE STUDY: SEA(FOOD) CHANGE IN HAND

Alan, who was 58, worked as a college instructor in the Processing Machinery Maintenance and Repair Program for more than 12 years. He began this vocational program — one of several that offered retail operations open to the public to provide students with experience and hands-on training in maintaining and repairing manufacturing equipment used in the seafood canning industry. 

Students received training in welding, hydraulics, pneumatics, vacuum pumps, air compressors, electricity and power transmission. The machinery came primarily from seafood harvesting and processing companies prevalent in the Pacific Northwest and Alaska areas of the U.S.

Standard operating policies and procedures
Private sector companies shipped inoperable machinery and equipment to the college at their own expense. The college entered these items into its inventory and subsequently scheduled them for repair. College policy required the instructor to maintain a log of all prenumbered work orders to track job costs and keep a record of all documents and correspondence related to each transaction. The instructor assessed the status of each item and ordered the parts and supplies he thought would be needed for the work. 

The college charged each customer enough to recover direct and indirect costs on each repair project; the minimum charge started at $10 plus parts, supplies and labor. The college required all customers to make 50 percent deposits of estimated machinery repair costs when they placed their orders. Alan then taught the students how to repair the machinery. Alan was required to list on work orders all parts, materials, supplies, labor and transportation costs to ship the equipment back to the customer when the students completed the projects. Customers reimbursed the college for all repair costs. Finally, the college shipped the repaired equipment back to the customers after it received payments. 

Programs don’t always run like they should
Trade-skill education programs usually begin with the best of intentions. However, somewhere in the process, the needs and wants of program managers sometimes get the best of them. They might take advantage of management’s lack of monitoring and begin to operate programs for personal benefit. Fraud schemes may exist for a number of years and result in huge losses. Sometimes, the effects are so severe the schools have to terminate the programs. Private-sector companies operating similar programs may even go bankrupt. Worse yet, entities may not have the necessary residual funds to prosecute perpetrators. 

Despite red flags, no fraud detection
In this case, the college had plenty of evidence alerting it to irregularities. Alan didn’t maintain the required accounting records, and the program ran in the red during the four years he operated this scheme. He frequently asked for and received his supervisor’s approval to exceed the program’s budget for supplies. The college security chief confirmed student reports of suspicious equipment repair transactions and unusual shipments from the program’s workshop. Alan gave plausible explanations for these problems. 

After a cursory review, the college only reprimanded Alan for program inadequacies. However, the college had previously reprimanded him for poor recordkeeping, making personal telephone calls at work and selling scrap metal from the program to raise money for a student barbecue party at his home. 

The college apparently didn’t take the most current student complaints seriously after the second reprimand because it didn’t further investigate the program. It even advised students not to inform the college’s external auditor about the problems. So, Alan continued business as usual, and the director responsible for monitoring the program never analyzed the accounting records and other reports to find reasons the program wasn’t financially sound. 

External auditor listens to students
Alan’s scheme began to unravel when students finally voiced their concerns directly to the external auditor who then planned a special audit. When he heard rumors of the audit, Alan immediately went on extended sick leave and told the college that he didn’t know when he would be able to return to work. A replacement instructor briefly reviewed the program’s records and found that program expenses exceeded revenues by US$372,067.93 in four years, and the value of the work-in-progress inventory had increased significantly over this same period. 

The college told its external auditor about these irregularities two days later, and the audit began immediately. External auditors discovered that many of the program’s accounting records had been destroyed, and they never found them. Apparently, Alan had attempted to conceal program irregularities from the college and thwart the audit. As we discussed in the January/February 2013 column, accurate accounting records are essential to establish whether a fraud has occurred in trade-skill education programs.

Because the external auditors initially believed the size of this case would be significant, they resorted to extraordinary audit steps to complete their work. They reviewed all available program records, interviewed students and then issued administrative subpoenas to all known private sector companies that had shipped equipment to the program for repair. In fact, the auditors performed the majority of the audit based upon the documents and records these companies subsequently submitted to them. These records included all correspondence and canceled checks associated with all transactions between the companies and the college. The bank endorsements from the canceled checks identified Alan’s secret bank account in which he deposited the checks. They also provided the necessary information to establish probable cause for the external auditors to issue an additional administrative subpoena and discover the extent of the funds diverted from the program without the college’s knowledge.

Alan declined to discuss any of the initial irregularities the external auditors had found in the program. He stated that there was simply a misunderstanding about how the program operated and that all questions would be resolved as the investigation matured. But as the external auditors suspected, nothing could be further from the truth. The program was in total disarray. 

During the audit, Alan retired — about five months after he had gone on extended sick leave. Then he disappeared. The external auditors later found out from his relatives Alan’s new address in American Samoa. Private sector companies involved with the college’s equipment repair program slapped him with civil lawsuits. Many companies claimed he owed them money because their equipment was missing from the program’s workshop. Alan, without his supervisor’s approval, apparently scrapped or sold this equipment to other private sector companies. No one determined where the equipment went. These litigation costs practically exhausted all of Alan’s personal and retirement funds.
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