Mike Billings of The Building Co. (TBC), a building contractor with $8 million in annual revenue, became concerned about the activities of his 50/50 business partner, Steve Grey. Grey had not prepared certain internal financial documents, including a statement of partner draws for the current year and standard financial statements, which Billings had requested months earlier. Based on his concerns, Billings conducted an initial review by analyzing selected disbursement transactions and identified multiple transactions executed by Grey to benefit his other businesses, including one for $300,000.
Shortly after Billings established TBC, he brought Grey in as an equal partner based on their prior work history and Grey’s strong sales background. Although neither partner ever signed a legal partnership operating agreement, Billings acted as president and the only named officer, while Grey held the title of vice president in filed tax documents.
Each partner drew a salary, and an informal agreement between the partners allowed each of them to pass certain agreed-upon personal expenses through TBC as distributions. Based on the agreement, the partner with the lower amount of distributions at year-end would receive a cash distribution to equalize distributions between the partners.
While Billings focused on expanding the business, running projects that he sold, and developing TBC’s business strategy, Grey’s responsibilities included tracking costs and revenues for his projects, day-to-day general office operations, marketing and advertising, and maintaining the books and records. Although Grey had no accounting or other education related to handling business finances, Billings trusted him fully.
After the initial analysis, Billings contacted counsel and forensic accountants to conduct an investigation. Counsel directed the investigation to ensure privilege was maintained. The forensic accountants obtained forensic images and performed a forensic analysis of all of Grey’s computers and business cell phones. In addition, they analyzed all relevant financial documents, including corporate and personal credit card statements related to Grey’s activity. The investigation focused on:
- Extracting all accounting and financial data from the accounting software for the period under investigation.
- Obtaining all relevant contracts and supporting documentation.
- Leveraging Billings’ knowledge of Grey’s other businesses, his familiarity with TBC vendors likely used based on home improvements Grey had completed, and his understanding of credit card charges that were not related to TBC’s business.
- Interviewing TBC employees to understand internal controls and address specific topics related to the investigation.
- Communicating with management frequently to keep all stakeholders abreast of evolving issues.
Investigators determined that over a three-year period, Grey embezzled more than $450,000 to support his excessive lifestyle, which included gambling, and frequent and expensive trips to strip clubs that allegedly also included prostitution.
As part of his scheme, Grey used his corporate credit card to incur a portion of those personal expenses and had TBC pay those charges without Billings’ knowledge. Those charges included taking himself and other TBC employees on gambling trips and spending extravagantly at restaurants and strip clubs. Grey recorded those transactions as “client/customer entertainment” in various general ledger accounts. He would then exclude these transactions from the shareholder distribution reports he generated.
Additionally, Grey executed two schemes to pay off his personal credit card charges. He would submit and approve his own expense report, and then issue himself a check from TBC (which he also signed) or he would issue a direct payment from TBC to his personal credit card company. The identification of improperly deducted nonbusiness expenses led to additional technical accounting and tax issues that required resolution.
Grey also provided a bridge loan to a TBC employee buying a house. During a discussion with the individual who received the loan, he stated that Grey charged him $15,000 in interest for the 30-day loan, which Grey kept. Grey returned $250,000 of the $300,000 bridge loan to TBC.
When examining TBC’s internal controls and relevant financial information, the forensic accountants determined that Grey exerted full control over the financial processes and information at TBC and was able to manipulate financial information provided to Billings and stakeholders. Grey altered his project profit reports to exclude nonbusiness transactions he posted against the project in the general ledger either just before or just after a project’s completion. Project reports clearly showed additional costs being added to Grey’s projects at, or near the time of, job completion.
Grey also manipulated TBC’s general ledger by mischaracterizing and falsifying descriptions for personal transactions, such as upgrades to his personal residence and new appliance purchases. This was determined by vouching general ledger transactions to reliable/competent supporting documentation or, in some instances, missing supporting documentation indicating the transaction was valid.
He also disguised nonbusiness transactions by identifying them as charge-backs on a project profit report or classifying a personal vendor payment as a subcontractor expense. In many instances, he recorded the false charge-back transactions in the subcontractor expense category because this represented the largest expenditure for TBC, and Billings never reviewed this account in detail.
In addition to the lack of segregation of duties related to the financials, investigators also discovered that Grey signed most checks and interacted with, and supervised, the outside part-time bookkeeper, who recorded transactions as directed by Grey. He also controlled the interaction with the tax accountant and provided all related financial information without Billings’ knowledge. Unfortunately, due to TBC’s deficient IT infrastructure, its server did not back up the accounting system, so all accounting-related information before 2012 was lost.
Ultimately, Billings bought Grey out of the business for a price that factored in the embezzled funds, but elected not to press charges to avoid the negative public relations impact and the potential for lost customers. TBC, Billings, and Grey had to refile three years of business and personal tax returns and had to pay additional federal taxes and penalties.
- The risks presented by this type of partnership can be mitigated in a variety of ways, including the nonfinancial partner reviewing bank statements and cancelled checks, receiving automated financial reports directly from the accounting system, or having an outside accountant review information periodically.
- Agreements related to formulating business arrangements must provide specifics regarding responsibilities of each party, which auditors can then use as the basis for audit procedures and to establish expectations.
- Internal auditors should work with counsel to ensure compliance with laws and that potential legal impacts of investigations are fully considered.
- In small and medium-size businesses, internal audit should ensure stakeholders participate in the internal control environment. This can include implementing monitoring controls, such as separate individual review of financial reports and involving all necessary parties with external relationships related to financial filings.
- There should always be a secondary review of checks to verify the supporting documentation, payee, and amount are appropriate.