Purchasing Department Fraud – A Major Threat and Hard to Detect

By B.J. Hoffman
Special to the Legal

In my last post, I highlighted that most organizations lose 5 percent of annual revenues to fraud, waste and abuse – a staggering figure that can mean the difference between a firm’s survival and its demise, especially in challenging economic climates.

One of the greatest fraud risks that you and your clients face is within the purchasing function, as a tremendous amount of funds flow through most companies’ cash disbursement and purchasing departments. Unfortunately, purchasing frauds can be among the most difficult to detect, owing to the fact that they are often conducted “off the books” by way of vendor kickbacks to employees.

Kickbacks to employees represent one common purchasing fraud, but other schemes include payments to fake vendors, bid-rigging and false invoicing for services not performed or goods not received. Typically, these frauds involve a company purchasing agent who has been “compromised” by a vendor who seeks to do more business with the company. The scheme may begin with small tokens of appreciation given to the employee responsible for purchasing, including tickets to sporting events, meals and gift certificates. While not all gifts from vendors to company employees indicate the presence of fraud, the presence of vendor gifts should pique management’s interest and lead to greater scrutiny over vendor/employee relationships.

Employees experiencing financial difficulties are particularly susceptible to such schemes, as they tend to be more able to rationalize the acceptance of kickbacks, so as to alleviate their financial or lifestyle pressures.

Indicators of possible kickback schemes include:

• Unexplained increases in operating expenses, measured as a percentage of company revenues.
• Poor purchasing department documentation regarding vendor selection and bidding processes.
• Excessive entertaining of purchasing staff by vendors.
• Poor cash management practices (the payment of certain “preferred” vendors immediately, instead of the standard payment timetable).
• Receipt of substandard goods/services from certain vendors (possibly an indicator that the vendor is recouping its kickback costs by substituting inferior products at delivery).
• Unexplained lifestyle changes among purchasing department staff (increased spending without a known sources of funds).

Among the ways management can prevent kickback schemes are:

• Get control over company expenses by adopting budgets and by measuring actual performance against those budgets.
• Adopt vendor selection policies, so that management (outside of the purchasing department) has discretion over the approved vendor list. Changes to the approved list would require management approval.
• Secure competitive bids for major expenses and strictly control the bidding process, so that management is closely involved in the receipt of sealed bids. Regularly check competing prices in the marketplace.
• Adopt strict gift acceptance policies and procedures for employees and compel the employees to annually acknowledge the policy. Similarly, many companies require outside vendors to agree to not offer gifts to purchasing department personnel.
• Monitor the quality of goods and services received from vendors.
• Segregate duties within purchasing to separate purchase authorization from the receipt of goods, and from the disbursement of funds to vendors.

Kickback schemes within purchasing departments are difficult to detect, since accounting records will continue to reflect cash disbursements to legitimate vendors for actual goods and services received. However, the prices paid for such goods and services will be higher than normal, and the quality of the goods received will often be below standard.

The adoption of effective policies, procedures and controls within your purchasing department can go a long way in the effort to minimize the losses every organization incurs from fraud, waste and abuse.

B.J. Hoffman is a certified public accountant and certified fraud examiner for Citrin Cooperman, an accounting, tax and business consulting firm. He is a partner in the Philadelphia office. Hoffman provides clients with a mix of audit, tax and litigation support services. He often works with closely held entities in a variety of industries including professional service firms and real estate enterprises. He can be reached at bjhoffman@citrincooperman.com or 215-545-4800.