Vendor Master File Fraud Detection and Prevention Using Data Analytics

5/13/2014
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Copyright © FraudResourceNet LLCCopyright © FraudResourcNet LLC
Special Guest Presenter:
Donald E. Sparks, CIA, CISA, CRMA
Copyright © FraudResourceNet LLC
About Peter Goldmann, MSc., CFE
President and Founder of White Collar Crime 101
• Publisher of White-Collar Crime Fighter
• Developer of FraudAware® Anti-Fraud Training
Monthly Columnist, The Fraud Examiner,
ACFE Newsletter
Member of Editorial Advisory Board, ACFE
Author of “Fraud in the Markets”
Explains how fraud fueled the financial crisis.

5/13/2014
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About Jim Kaplan, CIA, CFE
President and Founder of
AuditNet®, the global resource
for auditors (now available on
Apple and Android devices)
Auditor, Web Site Guru,
Internet for Auditors Pioneer
Recipient of the IIA’s 2007
Bradford Cadmus Memorial
Award.
Author of “The Auditor’s Guide to
Internet Resources” 2nd Edition
About Don Sparks, CIA, CISA, CRMA,
CRMA, ARM
• Vice President Industry Relations -
Audimation Services, Inc.
• Property/casualty insurance internal
audit experience (12 yrs. as CAE)
• Worked for two Risk Services firms
• The IIA – eLearning: GAIN, Flash
Surveys, & Role of Audit in SOX monthly
2 hour web tv broadcasts
• NAIC IT Working Papers Committee
• Co-Author of GTAG 13 & GTAG 16
• June 2011, Creator & Programmer
Auditchannel.tv
Don Sparks

5/13/2014
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Disclaimers

5/13/2014
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Today’s Agenda
 Awareness
 What Can Go Wrong
 Vendor Master File Policy
 Role of Internal Audit
 Red Flags
 Controls
 Risk Based Audit Plans
 Transactional Tests
 Questions
Awareness
 Duplicate vendors left in the vendor master file are
the leading cause of duplicate payments
 The creation of an imaginary vendor (shell) or use
of a dormant account can start AP fraud
 Reducing vendors not used recently or with stale
data will improve efficiency of payable operations

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Role of Internal Audit
According to the Red Book (IPPF):
 Assurance – Auditing the “Vendors”
 Consultant‐ Reporting and assisting an internal
committee with vendor master file oversight duties
including investigation skills when allegations of
fraud arise
What is Vendor Master File
The VMF is a key component of a company’s accounts
payable system.  This file contains the names,
addresses, TIN’s, and payment terms of each vendor.
The VMF becomes the control of every payment
processed by the accounts payable system and
therefore strict policies and procedures must be
established and maintained.  If not significant errors
and fraud will result.

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What are the 3 key steps to preventing VMF
Fraud?
A. Remove duplicate vendors
B. Rigid and formal check signing authority levels
C. Due Diligence process for detecting Shell companies
D. De-activate dormant vendors to prevent further usage
Polling Question 1
Beware of Slippery Slope
1210‐A3‐ Proficiency Standard: “Internal auditors
must have sufficient knowledge of key information
technology risks and controls and available
technology‐based audit techniques to perform their
assigned work”
Problem: The only source of knowledge is
experience – Albert Einstein

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Black Balled Firm Back
The Internal Audit department of a northwest Chicago suburban location
discovered a fraud that went on for over ten years.  Recently a long term
employee decided to retire.  A couple of days after retirement, a tenant in
the building owned by the insurance company questioned why they no
longer received their mail.  The employee that retired always went to the
post office each day and picked up the tenants mail and daily newspapers.
But now the tenants’ allegations are that a service they paid for a year in
advance was no longer being received.  The chief audit executive was
unaware that the company offered tenants this service and asked the
tenants to produce an invoice.  The tenants found the original invoices
which indicated the tenants were to make their checks payable to the
same company the insurance company used for nightly cleaning services.
The chief called for a committee meeting, a committee that reviewed
modifications to the vendor master file and learned that three executives
had formed a company to provide the cleaning services and falsified the
required every 3 to 5 year competitive bidding document.
Employee‐Run Service

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What Can Go Wrong
What Can Go Wrong

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Shell Company Scheme
For $150, Paula was “in business.” That small
investment bought a company name or DBA (doing
business as) certificate — which was the key to her
grand plan to defraud her employer. She used the
certificate to set‐up a business checking account and
then added the new enterprise as a vendor in the
accounting system. A few days later she submitted her
first invoice for payment. Her boss, the owner of the
company, never noticed. Paula stole nearly $860,000
over the next six years.
 Invoices, purchase orders and receiving reports must be
matched before payment issued
 Purchasing department should be independent of receiving,
shipping and accounting
 Purchases must have management approval of
acceptance/completion
 Maintain a current approved vendor list
 Use competitive bids for major purchases
 Vendor purchases should be reviewed for abnormal levels
 Control methods should be implemented for duplicate
invoices/purchase orders
Controls To Consider

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According to the IPPF, Internal Auditing
provides these two services?
A. Compliance with laws and safeguard assets
B. Assist management in the completion of its goals and
objectives
C. Assurance and Consulting services
D. Determine the integrity & reliability of financial and
operational information
Polling Question 2
Do you have a VMF policy?
An effective vendor master file policy includes :
1. Regular reports on activity – continuous monitoring
2. Regular communications with vendors
3. A consistent naming convention
4. Rules addressing vendor additions and deletions
5. Regular cleaning and purging duplicate, merged
companies, old or dormant accounts.

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VMF Activity Reports
Quarterly
 Additions
 Deletions
 Record Changes
 Looking for Duplicates
 Compare to IRS TIN
 Regular cleaning of the VMF can eliminate
accidental duplicate payments
 Annually do the same just before 1099 time
Naming Convention
VMF name should match the W9 report with all
punctuation removed
 New invoices with a different name go to a
supervisor
 Supervisor contacts the company and resolves the
discrepancy
 Abbreviations are used only if on the W9, or the
name is too long to fit on the payee line of the
check

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Vendor Background
Checks
 Review industry watch‐lists
 Conduct a corporate registry search
 Search politically exposes persons (PEP)
databases
 Verify the vendor’s key individuals
 Verify the vendor’s insurance
 Verify professional licenses
 Check with at least 3 customers using the vendor
What is a Shell Company
A company that does not have a physical presence
and generates little independent economic value.
Perpetrated by vendors or employees. Three part
process:
 Setting up the shell company as a vendor
 Submitting an invoice
 Obtain payment approval for the fake invoice

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Leonard Vona Quote
“Shell companies are legal entities that are frequently
used by individuals to conduct criminal behavior. Such
fraudulent measures include money laundering,
billing schemes, fictitious service schemes,
bankruptcy fraud, tax evasion, as well as market
manipulation. While authorities are continuously
investigating the illegal utilization of shell entities,
they are finding it difficult to prosecute those whom
are criminally involved. States do not require much, if
any, ownership information on company formation
documents, therefore, making it almost foolproof for
law officials to prosecute.”
Shell company Statistics
Unfortunately, this story is far too common when it
comes to small business fraud. According to experts,
shell company schemes, where a fake entity is
established by a dishonest employee to bill a company
for goods or services it does not receive, represent
about half of all fraudulent disbursement schemes.
All it takes is a greedy employee. In many cases the
scheming can last for years. The Association of Certified
Fraud Examiners (ACFE) pegs the median loss from shell
company schemes at nearly $600,000.

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Beware of the Red Flags of
Fraud
 Invoices cannot be traced to shipments
 Multiple payments to single vendor on the same date
 Pattern of purchases just below review level
 Unusually quick turnaround of invoices
 Payment to multiple vendors for the same product
 Extreme inventory shortage
 Expenses increase dramatically
 Unexplained rise in cost of goods sold
 Unexplained decrease in gross/net profits
 Excessive materials orders
 Goods not purchased at optimal reorder point
 High level approval of a low level transaction
Red Flag Indicators for Billing
Schemes
 • Invoices for unspecified services or “soft” billings such as consulting or
advertising
 • Unfamiliar vendors
 • Vendors with P.O. Boxes only
 • Vendors with company names consisting of initials only
 • Rapidly increasing purchases from one vendor
 • Vendor billings more than once a month
 • Vendor addresses that match employee addresses
 • Large billings broken into multiple smaller invoices
 • Internal control deficiencies, i.e., budgeting, approval levels
 • Unfolded invoices which may indicate they weren’t mailed

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What is a shell company?
A. A company that does not have a physical presence
B. Does not provide goods or services
C. Perpetrated by vendors, customers or employees
D. All of the above
E. None of the above
Polling Question 3
Red Flags
1210.A2‐ Proficiency ‐ Internal auditors must have
sufficient knowledge to evaluate the risk of fraud and
the manner in which it is managed within the
organization

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Use a COSO Framework for
Consulting
Assurance Role Objectives
 Procurement policy and procedures followed in
obtaining the goods and/or services
 Payments made to the vendor comply with
applicable invoice or purchase order requirements
 Free of conflicts of interest/business conduct issues
 (Vendor employees) in compliance with internal
Code of Ethics and Conflict of Interest Policies
 Compliance with the Master Service Agreement and
other applicable contracts
 Agree to open, independent and objective audit

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Best Time To Audit
2010 – Planning:  “The chief audit executive must
establish risk based plans to determine the priorities
of the internal audit activity consistent with the
organization’s goals”
Two ways:
1.  Traditional comparison of current period to
prior period(s)
2.  Risk Scoring (many in development)
Traditional Selection
Descending

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Traditional Selection
Ascending
What are some red flags of vendor master
file fraud?
A. Invoices can not be traced to shipments
B. Payment to multiple vendors for the same product
C. Unusually excessive material orders
D. All of the above
Polling Question 4

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Risk Profile; Risk Rank Vendor
Deloitte – Chicago Spring 2014
Characteristics Red Yellow Green
SpendAmount >1m >500k >100k
Type of Spend Labor, allocations Material, equip Services
Contract Complexity High Med Low
ContractType Cost Plus Hybrid Fixed Fee
Relationship Origin Sole sourced Hybrid Competitive bid
Historical Relationship Poor Neutral Trusted Advisor
Business Results/Issues Open civil/
criminal,bankruptcy
Multiple
undisclosed
related entities
No undisclosed
related entities
Analytical Results/Issues Many exceptions Some
exceptions
No exceptions
Audit Rights None Standard Strong
Vendors Structure Decentralized Some issues Centralized billing
and accounting
Risk Profiling – Selection
Framework
Deloitte Chicago Spring 2014

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Best Solution –
Transactional Tests
Since uncovering errors and fraud are sometimes like finding a
needle in a haystack, it is important to analyze the data from
several different perspectives. For example, duplicate testing
on different combinations of fields (name, address, bank
account number, tax ID number), as well as sophisticated
matching methods (e.g. full name match, part name match,
sounds like match) between employee and vendor files work
well for this type of analysis.
Auditing vendor files is generally the best way to quickly risk
assess where the issues may lie, as auditing transactional data
can be overwhelming. Therefore, once you’ve cleaned house
within the vendor master file, you’ll be ready to move on to
analyzing transactional data, now armed with a list of vendors
that are most likely to cause failure.
Tech‐Enabled Tests
1. Scope analysis of top 20 vendors during a three
year period. (looking to see if vendors in the top are
replaced and why if they are good)
2. Risk assessing your current vendor master file
3. Vendor Setup
4. False Vendors
5. After the fact purchase orders
6. Test round sum of payments
7. Payments to vendors almost immediately after
setup

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Name some good areas for companies to
consider continuous monitoring?
A.   Vendor Additions/Deletions/De‐activations
B.   Vendor Record Changes
C.   Vendor Industry Watch‐Lists
D. All of the above
Polling Question 5
Tech‐Enabled Tests
8. Payments from inactive vendors
9. Stratification or pivot table payables approval levels
10. Benford's law
11. Holding credit balances on inactive accounts receivables
12. Inconsistent invoice number length test
13. Nepotism ‐ adding relatives that live in same house to
employees
14. Payments to PO boxes
15. Round number tests
16. Payments on weekends or late at night

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Conclusions
Major Steps to Avoid or Reduce Vendor Fraud
Be sure vendors are legitimate before you start obtaining
goods or services – look out for “shell” company fraud
schemes
Do not conduct business with vendors that will not sign your
conflicts of interest, business conduct statements or right to
audit policies
Background checks must be issue‐ free – do your due diligence
Control vendors and reduce risk with Master Service
Agreement and other applicable contracts
How often should an organization look for
dulicate vendors and shell companies?
A. Upon receipt of invoices with differing company
names (or the invoice numbering scheme is not
consistent)
B. If invoices can not be traced to goods or services
C. If the invoice received for payment does not appear to
have been received in the mail (no fold creases)
D. All of the above
Polling Question 6

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Conclusions
Major Steps to Avoid or Reduce Vendor Fraud (part 2)
Separation of duties – approval of vendors in the master file
handled by an operation other than the area that reviews
receipt, acceptance and payment for goods and services
“Black‐balled” vendors stay dormant in your VMF
Eliminate manually written checks. Checks only issued to
those listed in the VMF.
Committee that approves all new vendors.
 June 11 Essentials of an Effective Fraud
Response Plan
 June 18 Quick Response Fraud Detection
Using Data Analytics
Coming Up Next

5/13/2014
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Website: http://www.fraudresourcenet.com
Jim Kaplan
FraudResourceNet™
800‐385‐1625
jkaplan@fraudresourcenet.com
Peter Goldmann
FraudResourceNet™
800‐440‐2261
pgoldmann@fraudresourcenet.com
Don Sparks
Audimation Services Inc
832‐327‐1877
dons@audimation.com

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