Dealership Fraud—Not in My Dealership!
Sadly, fraud occurs in dealerships in both up and down cycles and happens with more frequency than most dealers would like to believe. Without a systematic fraud program in place, fraud is nearly impossible to prevent, can be difficult to detect, and the financial impact of an undetected fraud can be catastrophic. The purpose of any fraud program is to provide a deterrent and to enable early detection prior to fraud becoming large enough to cause real financial pain for the dealership.
- In down cycles, a declining market can mask fraud—management believes poor financial performance is market-driven, rather than the result of fraud.
- In up cycles, increasing sales and profits can mask fraud-related “leakage” since “the dealership is doing great! What could be wrong, right?”
There are several areas within a dealership where fraud can occur, and the results can be devastating. One of our most interesting cases involved a huge fraud with the parts inventory being indirectly involved. The theme to keep in mind is separation of duties. A dealership had an A/P clerk who set up bank accounts for legitimate vendors and double paid a number of invoices each month. One set of payments went to the real vendor and the others went to the bank accounts the clerk had set up. Since double-entry bookkeeping requires a second entry, the clerk made a balancing entry reflecting a purchase of inventory. Over the period of a year, the parts inventory on the dealer’s statement grew from $300K to well over $1M, an unthinkably high number for all but the very largest dealerships. The dealer never suspected that anything was wrong until the store ran completely out of cash. The seven-digit fraud, of which very little was recovered, very nearly bankrupted the dealership. This fraud could have been prevented by any one of the following procedures:
- Segregation of duties such that the A/P clerk could not issue a signed check or wire transfer without signature from the business manager.
- Monthly review of the dealer’s statement. Had the GM, dealer, or business manager taken an hour to review the statement each month, they would have seen a steady increase in the parts inventory. An inquiry of the parts manager would have revealed that he had no knowledge of an increase in parts. The ensuing investigation would have stopped the fraud when it was less than $100K rather than when it exceeded $1M.Let’s review other areas where fraud can occur and look at safeguards the dealer can put in place to deter fraud.
Areas in a Dealership where Fraud is Most Likely to Occur
Used Car Department:
Used car managers have been “duking” since the inception of the business. The most common practices are wholesaling cars below true value, giving kickbacks when cars are purchased, reconditioning cars offsite in return for some personal consideration, and the practice of packaging of used cars when trading or wholesaling.
One of the more creative but sophomoric actions we have encountered is a case where the used car manager re-aged certain used cars on the used car month-end report since his dealer required all cars to be wholesaled at the 60-day mark. Another practice in the used car department—which may not technically be fraud, but which can be hugely damaging over time—is the inclination of the GSM of a store to arm-twist the used car manager into putting too much money into the trades in order to buy the new car business in a back-door fashion.
All of these practices erode the profitability of the used car department and are not easily detected without careful analysis, sometimes car-by-car, by the dealer. If undetected over time, the losses from these actions can accumulate to very significant losses. We have seen many used car inventories that were worth less than 65% of book value at the time of closing in a dealership sale. For example, when inventory was taken at one dealership sale closing, we asked “Where are the rest of the cars?” after we had spent just 15 minutes on the used car lot. The answer was predictable and unfortunate for the selling dealer.
Steps to Protect Against Fraud in the Used Car Department
- Institute a policy of dual control over the used car department by having someone knowledgeable other than the GSM walk the used car inventory car-by-car with the used car manager at least once a week. Grade and value each car and compare the values of the cars to the book value. If the values of any of the cars are out of balance vs. their book value, begin a detailed investigation of why. Used car managers will make an occasional honest mistake but a recurring theme can usually be detected by paying attention to the used inventory car-by-car.
- Institute a policy of no outside reconditioning. No trades should spend more than three days in reconditioning. All nonconforming trade-ins are wholesaled. All units to be wholesaled are bid by at least two approved wholesalers.
- Require a second approval (GSM or dealer) to purchase any units from other dealers or wholesalers. If cars purchased at auction consistently turn up overvalued, investigate why. Auctions are great places for the used manager to a) make an honest mistake or b) run a scam off campus and out of sight of the GM or dealer.
Parts and Service department:
Parts have commodity-like street value and can be monetized by thieves quickly and easily. Dealerships can get hammered both by theft of inventory and by bribes to employees with respect to purchases or sales of parts.
Dealerships must have security with respect to access to the parts inventory so that only authorized personnel can easily access the parts inventory.
Steps to Protect Against Fraud in the Parts and Service Department
- Controlling physical access to and from the building makes it difficult for employees intent on theft to get the parts out of inventory and into their personal cars or the dumpster for after hours pick-up.
- Weekly cycle counts are necessary and should be performed by a senior manager such as the business manager along with the parts manager. Any meaningful discrepancies are a red flag and should be fully investigated and resolved.
- Open account parts sales to independent garages and body shops must be tightly controlled by the dealer or GM. The parts manager is not paid to make credit decisions on sales to third parties. We have seen more than a few cases where given the opportunity, a dealership insider sells parts on open account to an independent garage or body shop as a result of a personal financial inducement. Not surprisingly, these accounts often fail to pay.
- Dealership personnel will often buy unnecessarily large amounts of aftermarket items in return for outright bribes or soft inducements such as vacations or golf outings. The result is the same: the dealership winds up with a multi-year supply of items that sit around forever and/or are finally blown out at a loss.
- The parts manager must have clearly defined parameters for what can be bought and all aftermarket or promotional purchases in excess of a predefined dollar amount or number of units must require GM approval.
It is not uncommon for parts and service employees to pocket cash payments. Although this is more difficult to do with a service repair order, it is simple to do with parts or accessories cash sales. Regular inventory cycle counts will reveal shortages once the shortages exceed normal shrink.
Fraud Prevention Summary
It is imperative that dealerships implement fraud policies or pay the price. The following is a guideline that any dealership can implement to protect ownership from fraud.
- “Tone at the Top”—leaders must set an example.
- Reduce opportunities for employees to commit fraud. Discover fraud before the theft is crippling to the dealership. Engage outside CPA firm or automotive consultants to assist in setting up and monitoring the fraud prevention system.
- Internal controls
- Controls over cash
- Timely preparation and detailed monthly review of dealer statements by dealer, GM and business manager.
- Fluctuation analysis of accounts on a monthly basis to identify any changes in trends or anomalies
- Segregation of duties
- Person who opens the mail doesn’t reconcile the bank account
- Develop an approved vendor list and compare invoices to this list
- Implement a purchase order approval system
- Accounting policies
- Monthly account reconciliations
- Bank statements sent to the owner’s house, not the store
- Inventory cycle counts and spot checks
- Be alert to
- Changes in employee behavior
- “Lavish lifestyle”
A well-designed fraud system can provide substantial deterrents to fraud and can maximize the likelihood of catching any fraud before the losses become catastrophic. Dealers would do well to engage outside consultants who specialize in such matters to assist them in the design and execution of an effective system.
Many of the potential problems in a dealership, including fraud, can be illuminated through the senior management team’s scrutiny of the dealer’s statement and comparison of the dealer’s results to the benchmarking statistics published by the manufacturers. Problems do exist in dealerships for which selling more cars is not the answer. Fraud prevention and efficient operations require ongoing committed effort by the dealer and his team.
J. Michael Issa is a principal at GlassRatner Advisory & Capital Group LLC. He is a CPA and a Chapter 11 Bankruptcy Trustee in the Central District of California. GlassRatner is a two-time winner of M&A Advisor’s “Middle Market Turnaround Firm of the Year” award and Issa earned “Middle Market Deal of the Year” twice, including for a very significant auto transaction in 2012.
Kerry Krisher, a fellow GlassRatner principal, CPA, and Certified Forensic Accountant, contributed to this article. Ms. Krisher has extensive experience in fraud examinations and in dealership M&A transactions.
MJ Vaughn, a Managing Director of GlassRatner, has approximately 40 years of combined experience in both the wholesale and retail side of the automotive business. MJ Vaughn has been involved in all aspects of managing, financing, restructuring and buying and selling auto dealerships. He has been responsible for over 70 successful automotive transactions during his career.