Mystery Shopping for Fraud

STEPHEN PEDNEAULT

Sang Min Lee and his wife, Soo Jin Lee, both middle-age natives of South Korea, owned a small, single-location jewelry store, where Soo Jin was responsible for the day-to-day sales and operations. On many days when not in school, the Lees' three small children stayed at the store, sitting behind the counters coloring, playing with their electronic devices or running in and out of the back storage area. Sang Min's mother occasionally worked at the store when Soo Jin could not. However, Soo Jin almost always ran the store during operating hours.

Matthew Morrison was a property and casualty claims adjuster with National Insurance. Nearing the end of his professional career, Morrison counted 24 years with National. Another National investigator, John O'Connor, worked with Morrison. O'Connor was a retired police officer who served with a local police department for nearly 30 years and concluded his law enforcement career as a sergeant. Too young to permanently retire, O'Connor launched a second career with National and had already logged four years.

Silver Star

The Lees operated Silver Star Jewelers, a small, local jewelry store in a strip plaza on an edge of Westford known for problems. The store occupied fewer than 1,000 square feet, with a public entrance facing the parking lot and a private rear entrance accessible from behind the plaza. An alarm system protected the property, and it featured a panic robbery component as well as fire and burglary systems. Silver Star did not operate a website, nor would consumers likely expect to find one for this level of retail.

Silver Star's retail space included one long glass counter with jewelry on display, visible to customers from the top looking down as well as from the front, looking into the display case.

The design limited behind-the-counter access to its far end, toward the rear of the store. The walls behind the counter held pegboard displays with miscellaneous items not typically associated with jewelry stores, such as hair extensions and head scarves. On the showroom floor stood several round clothing racks — once again, items not necessarily associated with a jewelry store. The store operated weekdays from 9 a.m. to 9 p.m., Saturdays 9 a.m. to 6 p.m. and was closed on Sundays.

Independent Expertise

I was working as an independent fraud examiner within the firm I established three years earlier, focusing on fraud examination, forensic accounting and litigation support on financial matters. I received a call from Matthew Morrison at National about a claim to which he was assigned. Morrison explained that the claim involved a property loss related to a business known as Silver Star Jewelers, and that he had worked for some time with O'Connor to understand the claim details and assess its legitimacy. The Lees told O'Connor they did not maintain normal business records and therefore based their loss calculations on created spreadsheets and handwritten receipts. Morrison said O'Connor had monitored the store's operations on a few occasions while sitting out in the parking lot and noticed that an older Korean woman also worked at the store.

Morrison also told me that he and O'Connor struggled with two barriers in the claim. First, neither Sang Min nor Soo Jin spoke any English, and each time either Morrison or O'Connor sought to elicit information from them, they needed a Korean interpreter. Second, Sang Min and Soo Jin told Morrison and O'Connor, through their interpreter, that the store did not maintain any means to track sales, and therefore, they could not provide any documentation to support the daily, weekly or monthly sales amounts they used to calculate and support their claim.

Morrison — and the case — had certainly gained my interest.

I gave him my background and told him that, based on my training and experience, I could get to the heart and facts of the matter. I asked Morrison what information I could review, and he rattled off a brief list of documents received to date. He agreed to scan and email me the insurance claim and documents for review, and so began my involvement in the case.

I identified other financial documents the Lees likely possessed and asked Morrison to track them down for me.

I read through the Lee's insurance claim; according to their narrative:

Once the Lees repaired the physical damage, they reopened for business with very few jewelry items in the glass display case. However, by the middle of the following week, the glass case once again brimmed with jewelry and the store functioned as before.

Shopping Trip

I knew what my first step should be: I called Jeff Mandel, a colleague and fellow Certified Fraud Examiner, and when he picked up the phone I announced: “Road trip!”

I picked up Jeff two hours later, and together we drove off to go shopping . . . for jewelry. During the ride, I explained the case and what I wanted to accomplish during this mission. We arrived at the plaza with Silver Star, parked discreetly and sat in the car to observe the store's activity for a while. Scanning our surroundings, we quickly realized that we weren't in the best part of town, and perhaps other jewelry shoppers felt the same way — we didn't see a single customer enter or leave Silver Star.

After a while, we went inside the store, which was empty except for an Asian woman behind the counter. I scanned the jewelry in the glass case while Jeff looked around the premises. As he walked around the few racks of clothes on display, I sought to “find” an item not on display and focus my shopping efforts on that particular item.

I noticed the display case held no charms and thus “found” my item. The woman stood up from her stool and walked over to me. She asked if I sought anything in particular. I told her it was my anniversary, and I hoped to buy my wife a charm. She replied she didn't have any charms.

Acting disappointed, I explained I lived in another area of the state and asked her if she knew where I might find a charm today. She suggested I try the Buckland Mall and gave me directions from the store.

I thanked her and told her I wanted to poke around a bit more to see if anything else might catch my fancy. I spied an inexpensive pair of gold earrings, and, as she put them into a box for me, I turned to Jeff, who had finished looking around, and told him I found something for my wife. Jeff played along like an experienced wingman.

I followed the woman down the counter and pulled out my cash to pay her. She rang up my sale on a cash register, and I handed her my currency. She gave me a receipt, my change, and a small bag. I put the receipt in the bag and thanked her for her help. I then (intentionally) haphazardly repeated the directions to Buckland Mall that she provided and listened as she laboriously ran through them again, based on the puzzled look I had put on my face.

Jeff and I walked back to the car, and I told him I considered the mission a success. I had accomplished my two goals, both of which Morrison found to be barriers in the past. First, I demonstrated that the woman understood and spoke English, giving me very detailed directions to the mall. Second, I learned that the store possessed and used a means with which to track sales: a cash register that also prints receipts.

From another plaza about a mile away, I called Morrison and updated him. Then I drove back to drop Jeff at his firm and put the earrings, receipt and bag into evidence.

Broken Paper Trail

A few weeks later I received a call from Morrison. He had more information produced by the Lees and wanted me to review it. Within a day, I met up with him to get copies of the records. I quickly glanced through them and recognized copies of tax returns, along with handwritten schedules. I noted to Morrison that I didn't see any paid invoices, inventory details or anything else I had specified for him to request of the Lees.

He said the Lees claimed these constituted the entirety of their records and that nothing else existed. Disappointed at the level of information produced, I returned to my office with the copies and added them to the evidence collected.

The next day I sorted through their records and focused my initial efforts on the tax returns, something I almost always do to get acclimated to the nature of the entity's revenues, expenses and balance sheet.

The tax returns comprised corporate returns: S corporations, to be specific, or Form 1120S, and it appeared they had produced complete copies of their filed returns for the past three years (seldom received in complete form in my world).

As I reviewed the most recently filed return, I noted the entity's year-end was October 31, and the return covered the period up through the October prior to the claimed burglary event.

I flipped to page 4 of Form 1120S (the balance sheet) and looked to see how much inventory they reported as of the October just a few months prior to the robbery. The inventory line item was blank. I moved to page 2 (the cost of goods sold) and looked for the beginning and ending inventory amounts. Both lines were blank.

I looked at the two prior years' returns and found the same blanks regarding inventory. I smiled because I knew the Lees had a well-stocked store and a back room full of inventory, but for tax purposes, they had expensed their purchases rather than treating the items on hand as available for sale as inventory. Tax fraud! I knew the first question I would pose to the Lees once I had the opportunity: “How could you suffer losses due to a burglary at your store just a few short months after your year-end, when you reported to the Internal Revenue Service that the store did not have any inventory?”

I turned my attention to the remaining schedules the Lees provided. The handwritten, columned analyses described items in the first column, price in the second column, quantity in the third and an extension of the value they had calculated (price times quantity) in the fourth. Without corresponding inventory schedules, I determined these constituted nothing but unsupported client-created schedules.

Worse, I noted most of the line items referenced bulk purchases of gold and silver, listing the weight and cost per weight for each line, rather than specific items of jewelry. The Lees' claim specified individually identified items lost in the burglary, but the supporting purchase schedules reflected bulk purchases of gold and silver. Nothing would enable me to match their lost inventory to any other documentation. They also failed to produce paid invoices or supporting documentation.

I called Morrison and told him that unless the Lees produced paid invoices, canceled checks and other supporting documents, I could do little with our information. Morrison suggested we set up a meeting to ask the Lees some questions under oath, an available tool similar to a deposition.

Under Oath

A few days and several emails later, Morrison and I had a date and location for the meeting. Morrison told me the Lees had retained counsel, attorney Jung Hee Kim. He also told me a court reporter and a translator would participate in the meeting.

The morning of our meeting, I prepared the conference room in my office building. O'Connor arrived first. While he determined who would sit where during the meeting, I retrieved the tax returns and schedules the Lees had provided and lined them up in front of where I would sit — near the end, close to the Lees, across the table and facing the door. I then put the bag, receipt and pair of earrings on the table in front of me, in plain view as attendees arrived.

The court reporter and translator arrived next and set up their work areas for the meeting. The Lees arrived second to last, followed by their attorney.

I'll never forget the image of Soo Jin Lee as she entered the room. She looked right at me, as if she remembered me but couldn't place me. Then she looked at the table and saw the bag, receipt and earrings. I clearly saw the light go on as she suddenly connected me with the sale at the store. Then she quickly looked away and sat down. Sang Min Lee shook my hand and sat down, as did Attorney Kim.

I looked over at Soo Jin Lee and asked her if she remembered me. I told her I had visited the store to buy earrings and pointed to the jewelry on the table. She nodded but didn't say anything. The translator asked O'Connor when she should start interpreting for the Lees. O'Connor told her she could sit back for now, as the Lees understood and spoke English, and her services would be needed only if there was something they didn't understand. O'Connor told the Lees he would swear them in and then turned the questioning over to me.

I started by showing the Lees their most recent tax return. I asked Mr. Lee if he recognized the signature on the Form 1120S. He said he did. I asked him if he remembered signing the return, and again he said he did. I asked him if he understood the tax return he signed. He said an accountant had prepared it but that he basically understood the tax return.

I asked him to turn to page 2 and show us the inventory amount the store had on hand as of October 31. Mr. Lee turned to page 2 but could not identify any inventory. I pointed to the lines that called for beginning and ending inventory and asked why the lines were blank. He said there was no inventory for tax purposes.

Next I asked Mr. Lee to turn to page 4 and point out how much inventory Silver Star had at the beginning and end of the year. He struggled through the balance sheet but couldn't find where the inventory should have been listed. I pointed to the lines for inventory and asked why they were blank. He again said there was no inventory for tax purposes. I asked Mr. Lee what method of accounting he used to track his business and file the tax return, and he seemed confused by my question. I asked him if he filed on the cash or accrual basis. He said, “Cash basis, we filed on the cash basis.” I asked him if he knew the difference, and he said he did not.

I asked Mr. Lee if he could provide copies of paid invoices reflecting the inventory purchased between October 31 and the date of the alleged burglary. He said he made few, if any, purchases between the dates. I asked him how that could be, reminding him that the store reported to the IRS that it had no inventory as of October 31, and yet just a few short months later the store lost its entire inventory as the result of a burglary. I said if the store had no inventory on October 31, he needed to buy inventory between October 31 and the date of the burglary, or the burglars would have found the store empty.

Mr. Lee stated, “You don't understand. It doesn't work like that. How we keep the records for the store are not the same as what is on the tax returns. Those are simply tax returns. There's no inventory on the tax returns — we don't track it like that.”

I asked Mr. Lee how he tracked it. He said, “We buy the inventory for the store. It is an expense. We write it off because we paid for it. There is no inventory at the end of the year for the tax return. We keep track of what is in the store for sale in ledgers.”

Hearing Mr. Lee describe and admit to tax fraud under oath with a court reporter taking it all down, I pressed on. “So let me make sure I understand what you are saying, Mr. Lee. You have inventory in the store and on your ledgers to keep track of things, but when it comes to filing your tax return, there is no inventory because you paid for it. Is that right?”

Attorney Kim piped up with “Mr. Pedneault, I don't think you understand the method of accounting he is describing. They have two methods of accounting for their inventory. It is expensed as they purchase it.”

Not having expected Attorney Kim to speak under oath, I looked over to him, rolled my eyes and asked him if he really wanted to continue this line of questioning under oath in the presence of a court reporter. I asked him if he thought it might be better to move on to another subject. I saw the light go on over his head as well, and he agreed perhaps we should move to a new subject. I knew I had them for tax fraud, under oath, and on the record.

I turned back to Soo Jin Lee and asked her if she kept the register receipts and tapes from the daily sales activity. Before she could answer, I held up my receipt and told her I knew she had a means to track the daily sales. Mrs. Lee said she threw away the receipts and register tape each night. How convenient, I thought; no one could ever determine their actual sales.

I focused my next line of questioning on the Lees' schedules of bulk purchases. I asked Mr. Lee to explain how the schedules worked and how they related to the stolen jewelry. Mr. Lee said he didn't understand, so we asked the translator to repeat the question in Korean. She did, and he responded to her in Korean. She said that Mr. Lee said it didn't work like that. He buys gold and silver in bulk. For example, he may buy 36 ounces of gold bulk, which represented three gold chains.

I asked how the bulk purchases connected to the listed items, and Mr. Lee said it couldn't easily be done, which was why he provided schedules showing that the store bought more bulk than the combined weight of all the listed items. When I asked him where the receipts and invoices supporting his purchases were, he said he always paid cash and that the scale weight slip served as the receipt (multiplied by that day's price for gold or silver). Many similar handwritten slips existed.

I asked if all of the bulk purchases went into the store's inventory, and Mr. Lee said some went into their other store in Massachusetts. Other store? The Lees had a second jewelry store? That was a revelation to me.

I asked Mr. Lee what records he maintained and could produce for his second store and was informed that both stores shared one set of records, including inventory and bulk purchases. The Lees also said they moved inventory back and forth between the stores regularly, depending on what sold well at each store. Great, I thought, a commingled mess! When I asked them to show me how they tracked inventory transfers, neither of them could locate the information on their records.

I asked O'Connor if we could take a break and speak in the hall. He suspended the recording, and we adjourned to the hall. I told him I did not believe a burglary occurred but that the Lees moved their inventory from the first store to the second one and filed the insurance claim. After investigators visited the first store, I suspected that the Lees moved the inventory back, thus explaining how they were able to restock with minimal purchases.

Settlement Discussions

Already on the same page, O'Connor asked if we should include Attorney Kim in our conversation. I thought it made sense for him to know what we thought and to understand that his client had committed — and admitted to — tax fraud.

Kim joined us in the hall, and O'Connor brought him up to speed. Kim said the Lees were good people, and he believed they suffered a loss. He said he could see the difficulties they would have in documenting their loss, but that he felt they did suffer a loss and should be entitled to something from their policy. He said the insurance company should make them an offer to settle their claim. O'Connor told him that because the Lees could not articulate their claim according to their policy requirements, the insurance company should deny the claim, but he would ask Morrison to resolve the dispute.

We returned into the conference room, and O'Connor ended the meeting. Kim and the Lees left, followed by the translator and court reporter.

I later learned Kim continued to pressure Morrison into paying the Lees something toward their loss, arguing they needed cash to rebuild their business. Morrison ended up settling the Lees' claim by sending them a check as final payment, but only for a fraction of what they claimed to have lost. Their claim was for an excess of $200,000 in losses, and they received a payment for $20,000.

About the Author

Stephen Pedneault, CFE, CPA/CFF, is the principal in a local public accounting firm he established to focus solely on fraud investigation, fraud prevention, forensic accounting and litigation support. An established speaker, author and professor, Mr. Pedneault has 24 years of experience in public accounting and fraud investigations.