Audit of Fraud & Fraud Detection TechniquesRTI, Nagpur

Exercise 3.3 - Checklist ( Based on ‘Fraud Detection’- By ICAI)

A fraud of a high magnitude was observed in a case in which a plastic component manufacturing company used the services of external vendors possessing moulds for manufacture of such components who, in turn, were doing business only for the above company. The raw material was sent to the vendors to process and return the components on the basis of norms fixed in advance. Apparently, the vendor was giving a good yield for the material and the company had no reason to complain. In reality, however, about 90% of the raw material received was mixed with scrap and processed. The balance 10% of unused raw material was used for personal consumption or sold outside and the proceeds pocketed. Since the volumes were high, even a mere 10% scrap mixed amounted to a raw material saving equivalent to Rs.25 laks annually. The quality control division of the company did not possess sufficiently sophisticated tools to evaluate the quality of components produced. Also, the norms of input-output ratios had not been revised for a long time.

This type of fraud came to light during physical verification of stocks by the auditors.

The auditors noted the following:

  • A huge pile, apparently of scrap, was observed on the vendor’s site.
  • The insurance policy taken out by the company covered the raw material expected to be used at the vendor’s site.
  • The physical raw material showed some shortages on comparison with records which the vendor was prepared to make it up to the company.
  • The pile of scrap was explained to be belonging to one of the neighbouring factories on account of storage space.

You are required to identify anomalies, if any, in the above case that could develop into further investigation.

If so, as an investigator, what further checklist would you develop?

Suggested Solution to Exercise 3.3– Checklist

The fact that the company had patronized the vendor for the processing of the raw material exclusively for some time called for deeper scrutiny of the firm’s credentials in terms of price offered and quality delivered.

The auditors were intrigued by the fact that a huge pile of scrap was found at the vendor’s site. This was anomalous as only raw material that was to go into the processing of the components was expected to be on the site. Also, the vendor was doing business only for the company and therefore, the factory site was not expected to contain material pertaining to other customers. Therefore, the identification of this material was significant. The explanation of the vendor that the material belonged to a neighbouring factory was a little unconvincing and too glib considering the factory site normally contains materials for processing and is not used for storing unrelated stocks. This would have led to further inquiries.

When this was taken up with the company, it was confirmed that the pile of scrap was not the usual production scrap accumulated over a long period of time.

The investigator then has an option to make a round of the entire premises and interview the factory personnel individually. This was a better way of detecting the truth as the workers were involved in the processing activity and the chances of one of them coming clean quite good.

In the process, one of the workers in fact, blew the whistle. The pile of scrap was found to be inferior raw material to be mixed with the company’s good raw material received for processing in a certain proportion. The raw material saved by stealth was disposed off and proceeds appropriated by the vendor at the cost of the company. The extent of the losses over time would require to be calculated

Other possible checklist

The following related issues would be relevant to building up and documentation of factual evidence that could implicate the quality control personnel and the vendor by focusing on production data, price and quality data.

  • The above situation must have involved quality control personnel, as there had been no attempt at detection or lodging complaint with the vendor for the inferior material. So, examine whether the quality manager and the supplier were too friendly. Check how many times had inspections been carried out, how often approvals given, whether any queries or complaints, were registered and the material rejected.
  • If any queries were so raised, what was the supplier’s response and how did the quality control manager satisfy himself?
  • How many times the supplier has given credit notes for rejection and work out the percentage in comparison to the total turnover of production.
  • Whether at any time any new vendor empanelling was considered and if, so, whether any resistance encountered from any quarter. This could also include attempts to put the existing supplier in good light by vague enquiries with unreputed parties
  • Is the supplier charging concessional rates as compared to the others? If so, this may happen at the cost of quality.
  • Carry out a physical check of stocks at vendor’s and reconcile the balances , if possible on a surprise basis, regularly.
  • Observe an entire production cycle and engage experts to ascertain the quality of rejection percentages that are acceptable. Whether the rejection percentages have been suppressed considering the technology environment prevailing at the site?

Exercise & Solution 3.31