Generous Contracts

I then asked the sales manager for the contracts with the major wholesalers, retailers and closeout
stores to look for agreements relating to sales returns, volume discounts and payment terms.
After this review (with the help of a translator and my colleague auditor who spoke Chinese), I
realized that the accounts were not correctly stated and that consignment sales in lieu of gross
sales should have been accounted for. To evaluate the accounting impact on the profit and loss
statement for sales returns, we obtained detailed statistics of sales quantities and values by
product for the past three years as well as obtained photocopies of all credit notes to manually
determine the quantities and values. The total amount related to sales returns was less than
$150,000.
To calculate an approximate impact on the profit and loss statement of the incorrect
accounting of consignment sales, we needed to know what quantities and values were typically
sold to each wholesaler and retailer as well as to understand the inventory turn rates. To do so,
we spoke to the IT department and obtained a data dump. Then, for the 30 top-selling products,
we analyzed the inventory transaction summary with detailed transactions of purchasing, sales
by and sales returns data for these articles.
Next we obtained from the customer service department which tracked the inventory
levels of each wholesaler and retailer the inventory on-hand figures as well as the
wholesaler/retailer sales information in all the stores. By merging and analyzing the various IT
data, we could prove that, on average, goods were maintained for 1520 days before being sold
to final customers. As a result, net sales were overstated, approximately $10 million. I initially
thought the internal controls might not have been working as planned, but I now started to look
at ST from another viewpoint. I started to believe the vice president of marketing when he said,
I believe the Lee brothers are defrauding the company.
By showing the transfer of goods to wholesalers and retailers as sales instead of
consignments, local ST management was capable of showing better-than-budgeted working
capital targets and reporting higher-than actual inventory turn rates.
I interviewed the marketing manager and learned how the local marketing budget
supported the companys business strategy in addition to the regional and worldwide strategic
initiatives. I asked how the marketing budget was assigned to events: camps for kids, TV
advertising, radio advertising, athletes/teams, merchandising and other expenses, and I got an
understanding of how some of these expenses were tracked to project codes in the accounting
system. I then inquired how suppliers for marketing services were selected, how competitive bids
were obtained and in what cases purchase orders were filled out. Furthermore I wanted to know
how services provided by third parties but not yet invoiced were captured in the accounting
system since these expenses should be reflected in the books at monthend. Unfortunately, the
marketing manager was not able to demonstrate to us how these liabilities were reflected; she did
not understand this accounting concept at all. As a result I concluded that there might be a
potential
risk of understatement of expenses and liabilities.
I then looked into the accounting books for a general ledger account called invoices in
transit, but could not find such an entry. I performed a search for unrecorded liabilities by
reviewing all supplier invoices that came in after month-end and verified whether they related to
a previous accounting period. This resulted in an understatement of expenses for tens of
thousands of dollars at the end of the quarter. This internal audit report is not going to be well
received, I said to myself.
I then requested copies of the contracts with teams, clubs and athletes in various sports to
get an understanding of what bonuses become payable to them and under what circumstances.
Most of the contracts were structured to be performance oriented. Athletes would typically be
reimbursed when they won a major event, and team owners would be paid based on the teams
ranking in its league. As part of the sponsoring/promotion contract, athletes would receive a
number of T-shirts, shoes and other ST products. Since the performance bonuses were substantial
and, given that ST had many contracts, I wondered whether the company had a database that
included details like the starting date, ending date, termination clauses, bonus payments due and
so on. Unfortunately ST did not have such a database, but I was given Excel files containing
most of the information I hoped to find. Not surprisingly, when we analyzed 30 randomly
selected contracts we found differences between the contractually agreed performance bonus and
the accruals recorded in the accounting books.
From the marketing and sales expenditures, we selected high-dollar transactions in the
general ledger accounts and traced them back to contracts to see that they were properly
authorized. Many contracts with sports federations and athletes were not signed by the marketing
manager, as specified in STs delegation of authority, but by the sales manager. It turned out that
an instruction from the marketing manager to all ST employees in English, informing staff that
he alone could approve sponsorships, was translated into the local language as all sponsorships
with athletes and teams must be signed by the sales manager.

And the List Goes On . . .

As I reviewed the aging of receivables, I was surprised to see large balances that had been
outstanding for more than one year. STs provision for bad debts did not take into account a
discount to reflect the current value of receivables older than a year. Again, I learned that
expenses were understated and started to doubt the accuracy of the books. I couldnt help but
think, What has this external auditor been doing the last couple of years?
After I finalized the sales and marketing cycle, I was going to focus on expenditures
(travel and entertainment, procurement and payroll) and was wondering what else I would find.
To review the travel and entertainment expenditures, we familiarized ourselves with the
companys travel and entertainment policy, the company car policy and the list of employees
with credit cards. We decided to review the expenses of the general manager, sales manager,
CFO and marketing manager as well as a random selection of sales reps since these staff
members were responsible for the bulk of the travel and entertainment expenses.
By reviewing the monthly credit card statements and a representative sample of travel
expenses for our chosen staff, we discovered that the supporting documentation for expenses was
often missing (leading to quite high non-tax-deductible expenses). In many cases simply a credit
card slip was attached to the claim for the expenses; the detailed expenses (restaurant bill, list
and function of participants, etc.) were generally missing and the name of the
business/establishment in which the credit card transaction took place was not easily identifiable.
Moreover, the general manager and sales manager were claiming and being reimbursed for
private expenditures. The VP of marketing was shocked when we told him; he had no idea
because he had never conducted a review of travel and entertainment expenses.
In addition, we investigated the purchase-to-pay cycle. Initially we familiarized ourselves
with the procurement policies (selection and evaluation of suppliers, obtaining different bids for
purchases over a certain value, when purchase orders were used, etc.). Then we followed up with
the procurement staff to get a better understanding of what activities they dealt with centrally
versus those decided by the department heads of individual cost centers. By downloading
supplier master data, supplier invoices, credit notes and payments from the accounting system,
we learned better what suppliers and supplier categories represented the major expenses. We
investigated trends, duplicate payments, breaks in numerical sequence, different suppliers with
the same VAT numbers, those with the same bank account details as employees and suppliers
with PO addresses.
Additionally I requested whether senior management and purchasing and sales staff
needed to sign annually a written conflict of interest statement declaring not to have shares or
interest in competitor companies with which ST did business. The personnel manager told us that
no such policies existed.
I asked a person from the ST Finance Department to search whether the Lee family
members had interests in other companies and learned that they had participations in or control
over five others. Not surprisingly, ST was buying products from two of these companies. After I
performed a quantitative analysis of what we were buying from them and comparing these with
market prices, I found out that the Lee brothers were charging ST above the market rate. The
annual impact of these purchases on ST was $300,000.
Another big chunk of expenses was payroll since the company employed nearly 1,000
people (including various regional offices). We performed a walk-through of the recruitment
process, learned how personnel data was entered into the human resources and time card systems
and learned how the information interfaced with payroll data. We looked at actual versus
budgeted personnel expenses by cost center, internal controls around the creation and
deactivation of employees in the payroll system, access controls over changes to remuneration
components and the controls when salaries were paid out.
We also tested for ghost employees by reviewing whether employees were part of the
time registration system and the telephone list. Regarding some of the employees who did not
appear on either the telephone list or the time registration, we were told that they were regional
sales employees. We asked whether they signed an application form for a corporate credit card or
mobile phone; when all these answers were negative, we asked the HR manager for their
personnel files, resumes and annual evaluation forms. We came to the conclusion that ghost
employees existed and the HR manager and Lee brothers knew about it.
Legal Advice
Once I had a relatively strong indication of fraud, I contacted the head of legal at ISC, Adam
Kowalski, who joined us in China. After he looked over the initial evidence, we discussed the
next steps in my auditing process and stayed in daily contact. Although Kowalski did not enter
the premises of ST, while in China he talked to various lawyers to get their opinions. Supporting
the case and showing the lawyers some of the evidence firsthand meant we had to make a lot of
copies. Kowalski also attended our exit meeting presentation to the Lee brothers.
When we explained the findings and accusations to the board of directors (which
included the Lee brothers), they responded with silence. Even after I directly asked them what
they thought of the situation, they did not say anything. The ISC board of directors bought the
remaining 50 percent of the shares of Sports Trading soon after the audit concluded. No criminal
charges were filed by ISCs senior management.