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Dealers Beware – Fraudulent Shell Companies may be Eroding the Sands of the Dealership’s Beach

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By Marilou C. Vroman, CPA, CFE

Dealerships are viewed as cash cows with deep pockets with substantial assets and revenues flowing through the operation.

As ocean waves subtly carry grains of sand away from the beach, diversion of cash and physical assets may occur in small increments over the course of time, and go virtually undetected. There are many ways a dealership may fall victim to fraudulent activity. With the high volume of transactions in typical dealerships, false billing schemes and fraudulent disbursement schemes paired with the creation of shell companies present a high risk of loss.

Most dealerships operate with the essentially the same employees and same vendors year after year. Low employee turnover and outstanding service from vendors can create a comfortable environment in which to operate, with little to no questioning of their business purpose or intent. Unfortunately, many dealers may not be aware of the risk that an employee or vendor is quietly siphoning cash or physical assets away from the company without detection.

Diversions of dealership cash or assets may be perpetrated through the formation and use of shell companies by an employee or related party. A shell company is a legal entity such as a corporation or LLC that has no real operations or business purpose. The entity typically does not buy, sell or produce anything of economic value. A shell company usually has little to no physical assets or cash and serves only as a vehicle through which cash or physical assets are transferred to its owner. While shell companies are often created for legitimate tax purposes, they may also be created for illegal purposes.

How is your dealership at risk?

Let’s consider for example a hypothetical and very profitable dealership “Stanley Motors, LLC”. Stanley Motors has an internet manager who also applies for vehicle incentives on behalf of the dealership. The manager has noticed that the accounting department is neither diligent in understanding certain incentive programs, nor are the incentives tracked effectively on the books. The incentive payments are often credited directly to income when they are received, and uncollected incentive balances are frequently written-off with little to no management involvement or questioning. The operating environment is optimal for a fraudulent disbursement scheme.

The internet manager has rationalized an opportunity to divert the funds away from the dealership for his own benefit. The savvy employee decides to create a legal entity using the name of Stanley Motors, Inc. (rather than Stanley Motors, LLC), and the state in which Stanley Motors operates requires minimal information to register a corporation. The internet manager completes an online form, pays a filing fee, and in minutes he has created a new legal entity. Once the entity has been formed, the manager goes to his local community bank and opens an account in Stanley Motors’ name. The internet manager continues to apply for incentive payments as normal and becomes more than willing to “assist” the accounting department by requesting all incentive checks be given to him for tracking and coding to the proper account. The manager codes and returns most of the checks to the accounting department, but selectively retains one or two payments that the dealership is not aware it is entitled to. Since the checks are payable to Stanley Motors, the manager simply endorses the check and deposits it into his own “Stanley Motors” account. The manager later withdraws the cash for his own personal use.

How could the dealership have prevented this scheme?

Several internal controls are designed to prevent diversion of funds. For example, the dealership’s mail should be opened by an individual who does not prepare the deposit and who has no responsibility for posting or processing transactions. Payments received should be recorded in a log as the mail is opened. The log should be provided to the Office Manager or Controller on a daily basis. The payments should then be receipted and recorded in accounting by an individual other than the person who prepares the deposit. Cash and checks should be placed in a safe until the deposit is prepared on the same or next business day. The payment receipt log should be compared to the cash receipts journal, the bank deposit slip, and deposit receipt to ensure all payments have been properly included in the bank deposit. In addition, the individual who applies for incentives should not have access to receive payments or post receipts. Furthermore, incentive programs and eligibility should be clearly communicated and understood by both sales management and accounting. All incentives applied for should be documented in the vehicle deal jacket, with a receivable set up by accounting for the amount due. Any “uncollectible” incentives should be confirmed as “ineligible” with the manufacturer and approved by management before being written-off. Fortunately, certain manufacturers pay incentives through a parts account or via electronic transfer, which reduces the risk of diversion. However, many businesses pay dealerships with checks and without strong internal controls, these checks may be easily diverted without detection.

A dealership may also fall victim to a fraudulent billing scheme through its purchasing function. For example, the hypothetical Stanley Motors dealership has a high volume parts and accessories business. The parts manager has observed frequent overages in the parts physical inventory due to billing errors and has discovered there is an opportunity to purchase parts without physically receiving the parts and recording them in the parts inventory (“PAD”). The scheme can be perpetrated by the parts manager forming a company in the same way the internet manager did in the previous example. The company may be formed with a local address and with a name that is indicative of an auto parts supplier such as “Excel Auto Supply”. Once the company and bank account have been set up, the parts manager can submit a signed check request or fictitious invoice with a false packing slip to the accounting department for processing. Since a manager has authorized the payment, a check will likely be issued by the accounting department without question. The manager may ask accounting to return the check to him so he can “hand deliver” the check to the vendor to “keep up good relations” through rapid payment. The check is then endorsed and deposited into the manager’s company account. The scheme will likely go undetected until a parts shortage is encountered and investigated. A savvy parts manager will track the physical inventory balance and compare it to the GL balance and adjust his frequency and dollar amount of purchases accordingly to avoid raising a red flag.

This example of a fraudulent disbursement scheme may also be prevented through strengthened internal controls. For example, vendors should be approved through a formalized process by a manager or department other than the department making the purchase. A vendor application should be completed and should include contact information, website, contact person, and federal tax ID. A background search of the company should be performed by the accounting department to verify that the vendor is valid and to identify whether the entity is owned or managed by an employee or related party to the dealership. The business phone number and address should be cross referenced to employee addresses. In processing vendor payments, purchases should be supported by a valid invoice and packing slip and be approved by a manager. The parts department should also indicate the repair order number or parts counter ticket number for special order parts purchases. As an additional control, the accounting department should have visibility to the parts PAD in the dealer management system and periodically verify whether certain purchased parts have been added to the inventory. Periodic surprise bin counts of high dollar value parts, or purchases from suspect vendors, will add further “perception of detection” which is a deterrent to fraudulent behavior.

Databases of legal entity names are typically available online through the state’s division of corporations. As an added control, a periodic audit of these legal entities should be performed to validate whether any companies have been created with similar names to the dealership’s legal name or its fictitious name (“dba”). In addition, the dealership’s vendor list should be compared to the employee list to for matching or similar addresses. Vendors should be verified annually to confirm whether the business is a valid entity in good standing with the state, and whether it is owned by or managed by a dealership employee or related party.

Dealerships should be wary of the risk of transactions with related parties and shell companies. Internal controls should be strengthened and management should be trained to recognize the signs to help prevent potentially fraudulent behavior. Invest the time and resources to shore up the dealership’s internal controls now before the pristine sands of the beach erode away.

Marilou C. Vroman, CPA, CFE is a principal at Axiom Advisors, a boutique automotive dealership consulting firm specializing in Mergers & Acquisitions, Enterprise Management and Litigation Support. She can be reached at mv@axiom-auto.com or 786-472-2805.

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