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| June 1 , 2005 | The
Newspaper of the NYSSCPA |
Vol.
8, No.10 |
War Story: Bookkeeper Defalcation
By Hunter Colby
Hal Meyer owned Bruno’s Pizzeria, a small chain of restaurants in the Milwaukee-Racine area. Hal inherited the business from his father, Bruno, who died suddenly of a heart attack before he could train Hal in the financial management of the business. As the sole owner, Hal had to rely on a long-time employee, Trudy Everett, for the business’ bookkeeping and banking expertise. Trudy was hard working, put in long hours, took only a fraction of her vacation time, and quietly handled all of her work without causing any problems for Hal.
The restaurants employed about 50 high school students as part of an ongoing community service project that Hal spearheaded when his father ran the business. Trudy enthusiastically supported the project, donating some of her own money to the cause, thereby impressing Hal as well as the other people who knew of her support. She was well liked by just about everyone who came into contact with her, and even won a benefactor award from her community service club, where she was a board member.
Hal was so busy running the business and supervising his employees and their schedules that he was grateful for Trudy’s expertise, which included the accounting software program she used to manage the business’s accounting and banking activities. Computers were entirely foreign to Hal, so he was doubly grateful.
Hal’s father had first engaged a CPA, Tom Roberts, to prepare tax returns and to prepare compiled and reviewed financial statements. When Tom offered to perform bank reconciliations as well for a nominal fee, Bruno accepted the offer. Tom’s engagement letter adequately addressed the scope and limitations of his tax work, reviews and bank reconciliations.
Unknown to Tom was the fact that Trudy had been creating false invoices for legitimate suppliers to the restaurant chain, abbreviating a supplier’s name with an acronym and depositing payments in her own accounts. For example, Restaurant & Bar Supplies became RBS on Trudy’s false invoices. Payment checks were then made out to RBS and deposited in an account Trudy opened after taking out a business license with a fictitious business name, Reliable Bookkeeping Services, also known as RBS.
When the business’ finances started to sag, Hal consulted with Trudy about possible approaches to improving the situation. Trudy recommended that Hal eliminate the financial statement reviews to save fees. As part of his review services, Tom Roberts would make inquiries of Trudy and Hal, but would not verify their responses to the inquiries. Hal agreed with Trudy’s recommendation, despite some stern warnings in writing from Tom to Hal about the lack of internal controls. Hal believed that Tom was just trying to protect his fees, and so eliminated the reviews while keeping the compilation services.
Despite a steady flow of customers into Bruno’s, finances continued to deteriorate over the next few years. Hal was having trouble meeting loan covenants for a large loan he had taken out a few years earlier, so he agreed with Trudy’s recommendation to lower the company’s employee-theft insurance policy from $250,000 to $100,000 in order to lower the premiums.
In light of the steady flow of business, Tom had been puzzled by the worsening financial picture for Bruno’s. He finally investigated payments to some of the suppliers and discovered Trudy’s fraudulent invoices and payments. Further investigation showed her embezzlements to be over $500,000.
Hal was, of course, devastated by the news and extremely disappointed that the CPA did not uncover the fraud earlier as part of the bank reconciliations. Since the CPA’s engagement letter did clearly define the scope and limitations of bank reconciliations and compilations, Hal’s expectations did not appear to be entirely justified. Hal was unable to borrow more money, due to the losses, and so he sued his CPA in a last-ditch effort to keep the business afloat. The CPA’s written warnings to Hal, however, combined with the engagement letters, caused the jury to side with the CPA, in spite of Hal being a highly sympathetic claimant.
Hal was forced to declare bankruptcy, close the restaurants, lay off more than 200 employees, and sell the restaurant’s furnishings and remaining supplies. Trudy was convicted of embezzlement and served a three-year jail sentence.
Loss-Prevention Tips
Jury studies show that most jurors would agree with the client’s expectation that a bank reconciliation, compilation or review will uncover fraud, especially if the client relationship is for more than a few years. The CPA therefore was wise to have a signed engagement letter describing the limitations of the services, as well as written warnings to the client about the lack of internal controls at the business.
Some of the red flags of embezzlement in this war story are:
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the lack of separation of duties in the bookkeeping and banking responsibilities;
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the long-time trusted bookkeeper working long hours and taking little vacation time;
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the change of ownership and management from Bruno to Hal, necessitating a redefinition of the engagement by the CPA;
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the sagging finances, triggering a duty by the CPA, when he learns of them, to offer services and agreed-upon procedures to check for problems; and
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the lack of understanding and involvement of the new owner in the financial recording and reporting of transactions. Small business owners cannot abdicate this role without significant risk. CPAs need to advise owners of this risk, convince them not to abdicate responsibility, and help them with financial education.
Editor’s Note: “War Stories,” drawn from Camico claims files, illustrate some of the dangers and pitfalls in the accounting profession. All names have been changed.
Hunter Colby, J.D., is a claims specialist with Camico and has over 17 years of experience in claims, with expertise in claims avoidance and mitigation procedures. He is a member of the California State Bar.
