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C H A P T E R

Franklin County Contractors:

A CASE OF CONCEALED LIABILITIES

PATRICIA A. PATRICK

Richard L. Franklin, III, was the owner of Franklin County Contractors

(FCC). He was a good-looking man — one of those men who looked as
though he spent a lot of time on a yacht with his year-round tan and expen-
sive yet casual clothes. But then, Richard did spend a lot of time on his
yacht. Richard was born into a very wealthy family with extensive real estate
holdings. His family was one of the wealthiest in the state. Richard had
looks and brains, and he graduated with good grades with a degree in
engineering from an Ivy League university.
After Richard’s father died, Richard’s mother gave each of the Franklin
children several large tracts of real estate. Richard’s tracts included several
stone quarries and asphalt plants, as well as significant commercial and resi-
dential real estate holdings. Altogether Richard owned and operated about
eight companies to manage his real estate holdings and business enter-
prises, and he even owned a company to manage the private plane he flew
to his vacation homes. Richard had several accountants and each of them
oversaw the books for one or more of his companies. FCC was one
such company, which Richard had formed to complete state highway
construction contracts.
Alan Baker had been the controller of FCC for more than ten years.
He had a bachelor’s degree in accounting but was not a Certified
Public Accountant (CPA) and therefore was not bound to uphold any
formal licensing requirements. Alan also did not possess any profes-
sional designations. Thus, he was not bound by any professional codes
of conduct either.
When Alan resigned from FCC, he said it was “time for a change.” The
real reason Alan resigned did not become clear to me until many months
after I replaced him as controller. I had been working for a large nonprofit

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228 Financial Statement Fraud Casebook

organization for the past five years and was looking for a challenge. I con-
tacted my former employer, a public accounting firm, and learned that
FCC was looking for a controller. I had participated in the FCC audit years
ago and recalled that Richard Franklin owned the company, but I did not
know anything about FCC’s current situation or its past. I accepted the posi-
tion as FCC’s new controller, but had very little accounting experience.
Still, I was excited to assume my role in the fast-paced industry of highway
construction. I was also aware of my professional responsibilities and
planned to carry out my duties with the highest integrity.

Throwing Stones
FCC was the general contractor for dozens of state government construc-
tion contracts for large sections of interstate highway. As the general con-
tractor, FCC bid and managed construction contracts, using the assistance
of subcontractors, as needed.
FCC owned a large stone quarry and asphalt plant. It also employed
about 300 semi-skilled, seasonal laborers to complete the highway construc-
tion jobs and about two dozen other job-related employees, such as superin-
tendents, purchasing agents and estimators. FCC employed about five
office staff to perform the accounting and administration functions. Rich-
ard owned a large fleet of heavy equipment, including tri-axle dump trucks,
front-end loaders, backhoes and asphalt pavers. This equipment was used
on the highway construction jobs, but on the advice of his lawyers, Richard
formed the heavy equipment as a separate corporate entity to avoid legal
liability, in the event that FCC was sued.
FCC was privately owned and operated by Richard, and I would not
be exaggerating if I said that Richard ran it with an iron fist — he had
a very bad temper and frequently flew into uncontrollable tirades. Rich-
ard wasn’t violent and never struck anyone during these rages, but he
did humiliate his victims and subject them to prolific profanity. Richard
frequently fired employees during these rampages but did not remem-
ber doing so later; he often had to rehire the terminated employees
the next day to keep the jobs moving. Since no one was immune to his
ire, I did not take the outbursts personally and simply waited silently
until Richard was finished. Some people became offended and walked
off the job, refusing to put up with the abuse. Others argued or simply
stood and cried.
Shortly after assuming my role as controller, I learned that FCC had
a long history of questionable behavior, which included alleged and
confirmed unethical and illegal acts with a direct and indirect impact
on the financial statements. I saw these acts as red flags of fraud and
organized them into the following categories: (1) management charac-
teristics, (2) operating conditions, and (3) industry conditions.
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Franklin County Contractors 229

Management Characteristics

FCC had a weak control environment and poor tone at the top — manage-
ment’s personal integrity and attitude toward internal controls. The inde-
pendent auditors annually cited FCC for internal control weaknesses, but
Richard failed to correct the problems. Most of these problems revolved
around a lack of separation of duties and a failure to restrict access to blank
documents.
For example, FCC frequently paid duplicate invoices and did not use a
voucher system. That would have prevented the payment of duplicate in-
voices by requiring proper approvals and documents for purchases, but
Richard never insisted the staff use it. Instead, Richard often signed hand-
written checks with little or no documentation for employees claiming
“emergencies” at the jobsites. Richard also had several signature stamps
and allowed various employees to stamp his signature on handwritten
checks. This resulted in checks that were written but not processed in the
accounting system. FCC also failed to control access to blank purchase or-
ders. Boxes of blank purchase orders were stored in an unlocked closet and
laborers frequently stole blocks of purchase orders and used them at local
hardware stores. We challenged these liabilities in court, but always lost.
These weaknesses, along with the ongoing lack of separation of duties, led
me to conclude that FCC had a poor tone at the top.
FCC had also committed a variety of tax and regulatory violations. Some
of these violations were confirmed; others were suspicions based on rumors
or hearsay. One of the known violations involved corporate income tax eva-
sion. Several years ago FCC received a state tax audit and was found to have
understated its net income by several million dollars. The company was put
on a payment plan to reimburse the state government for more than
$300,000 of back taxes, fines and penalties. Pursuant to this plan, every
month I had to hand deliver a $13,000 check to the state office of the attor-
ney general for FCC’s back taxes.
I frequently heard rumors that Richard instructed the laborers to il-
legally dump the leftover asphalt from paving jobs. Asphalt is a petroleum
product that must be disposed of in a certain manner. However, disposing
of asphalt properly involves substantial costs. The fleet manager and labor-
ers often hinted that it was better to not know how Richard got rid of his
excess asphalt from jobs.
FCC also frequently failed to comply with certain provisions of govern-
ment contracts. As controller, I soon realized that FCC had a tendency to
miss project deadlines. Richard also complained about paying the laborers
Davis Bacon wages on the government contracts. These are the prevailing
wage rates required on contracts that receive funding from the federal gov-
ernment. Davis Bacon rates are set by the federal government and are based
on job title and geographic area to ensure that employees on government
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230 Financial Statement Fraud Casebook

contracts are paid fairly. The bids that FCC submitted to the government
included Davis Bacon wages, so FCC was reimbursed for those. Still,
Richard tried to circumvent the wage rates if possible.

Operating Characteristics

FCC was having serious cash-flow problems. It could barely make payroll or
pay its current liabilities. Vendors and subcontractors called incessantly to
be paid on overdue invoices. FCC could barely pay the $13,000 a month
due to the attorney general for back taxes or make payroll. And I could not
pay vendors until these two priorities were met. As controller, most of my
time was spent managing cash flows and dealing with frustrated vendors.
FCC also had significant debt and debt service costs. The financial state-
ments indicated that FCC had about 65 percent debt financing, exceeding
the maximum amount of debt recommended by most credit-rating
agencies and banks. Most banks recommend debt in the range of 45 to
55 percent with the maximum amount at 62 percent. Sound financial
management practices advise against the use of long-term debt to meet
short-term operating needs (long-term debt should be used only for long-
term items, such as capital improvements, acquisitions and construction
contracts). Thus, FCC was already overleveraged with debt and seeking
more just to stay afloat.
Adding to these strains, FCC needed an unqualified audit report to
qualify for the bank loan that Richard was planning to apply for soon. If
FCC received a “going concern” audit report it would not qualify for the
new loan. A “going concern” audit report would signify FCC’s insolvency
and raise doubts about its long-term viability to lenders, vendors, subcon-
tractors and the state government. FCC was unable to pay the principal on
its debt and was just barely able to pay the interest on that debt, but this was
currently known only to insiders. A “going concern” audit report would let
outsiders know the extent of FCC’s financial problems. Richard was not
going to let that happen if he could help it because we needed the bank
loan to stay operable.

Industry Conditions

Highway construction is a highly competitive industry. State highway con-

struction contracts must be entered into via a competitive bidding process
and the government is required to generally award the contracts to the low-
est bidders. FCC routinely submitted the lowest bid on contracts and simul-
taneously managed more than a dozen highway contracts, totaling more
than $10 million. The jobs did not generate enough cash flows to keep FCC
operable, but the underlying reasons for this were unclear. Perhaps Richard
bid the jobs too low to cover the job-related costs, or maybe Richard mis-
managed the jobs. It is also possible that FCC’s fixed costs were too high
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Franklin County Contractors 231

relative to its revenues due to FCC’s excessive use of debt. Whatever the
reason, the jobs did not generate enough revenue to pay the subcontrac-
tors, vendors and debt service costs.
The industry was also highly regulated. As the general contractor on
government contracts, FCC was required to comply with contractual re-
quirements. These included paying Davis Bacon wages, meeting project
deadlines and using asphalt and concrete that met the government’s estab-
lished product quality standards.

Unexpected Job Duties

My responsibilities at FCC included supervising the accounting department
and overseeing the cash, accounts payable, accounts receivable, inventory
and payroll functions. I also hired and fired all the accounting and informa-
tion technology staff.
Things at FCC were always hectic. During my two years, we moved our
office location three times and converted our records to a different com-
puter system during each of these moves. Accounting software and informa-
tion technology for job-costing was changing rapidly at the time and FCC
was constantly seeking an accounting system that could accurately capture
job-related costs. These changes resulted in accounting-related improve-
ments, but also created chaos in what was already a very hectic operating
environment. The constant changes made it difficult for the accounting
department to keep up with its daily activities and to produce reliable
financial statements.
My job as the new controller was much more hectic than I had antici-
pated. I had heard that managers spent most of their time taking phone
calls and putting out fires, but it was the nature of the distractions at FCC
that raised my suspicions. Most notable were the constant phone calls and
surprise visits from vendors and subcontractors, claiming that FCC owed
them money on jobs that were completed before I was hired as controller.
Most of the subcontractors claimed we owed them as much as $300,000
for products such as concrete barriers and services such as line-painting.
The vendors alleged that we owed them for everything from equipment
rentals to hand tools. Most had clear memories about the circumstances
surrounding their transactions and claimed we were putting them out of
business by not paying the invoices. It was not unusual for them to cry on
the phone and insist on meeting with me. This led me to believe there
could be some truth to their claims.
I could not understand why FCC had all the outward signs of insolvency
(e.g., cash-flow problems, lack of liquidity, near inability to make payroll
and high debt service costs), but its financial statements reflected relative
solvency. These inconsistencies prompted me to look into the claims of the
subcontractors and vendors further.
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232 Financial Statement Fraud Casebook

Escalating Debts
I decided to unilaterally investigate the claims of the subcontractors and
vendors, and began by digging around in old desk drawers and file cabinets.
With little effort, I began to find packs of unrecorded invoices, vendor state-
ments and correspondence wrapped in rubber bands and stuffed into file
cabinets. The invoices seemed to support the claims of the subcontractors
and vendors, and many were accompanied by correspondence from the
creditors asking to be paid. These documents provided the evidence
needed to show that the work had been completed but not paid, just as the
subcontractors and vendors had alleged.
I verified the invoices with the superintendents who oversaw the work.
The superintendents said that, as far as they knew, the work had been per-
formed satisfactorily, but Alan almost never paid subcontractors. The super-
intendents said sometimes Richard feigned problems with the work to avoid
or delay paying the invoices. The superintendents believed the subcontrac-
tors should be paid.
After verifying each invoice with the job superintendents, I recorded
the related liability. Over the course of a year, I recorded more than $4 mil-
lion in unpaid liabilities. Because Richard had such a volatile temper, I did
not discuss my actions with him, but did give him monthly financial state-
ments, showing an ever-increasing amount of debt. Richard did not com-
plain or ask about the debt, although FCC’s financial statements now
reflected the true extent of its insolvency.

The End?
A few months later, FCC applied for a bank loan, using financial statements
that reflected the full extent of its debt and was turned down for the loan.
The bank’s decision was fatal, as FCC could not continue without the loan.
Shortly afterward Richard asked to meet with me “to discuss the debt on
FCC’s books.” I assumed that Richard was planning to remove some or all of
the debt that I had recorded so he could try again to secure the loan. Recog-
nizing that my meeting with Richard would most likely end in a dis-
agreement about the debt and my resignation or termination, I
immediately began to look for another job. As a CPA, I knew that I could
not misrepresent facts or subordinate my judgment to others. Thus, my po-
sition on the debt was firm.
Richard finally came to my office about two months later (I had al-
ready secured a new job by then, but had not given notice to Richard).
Richard went through the open accounts payable file and reviewed each
invoice, tearing up many of the subcontractor and vendor invoices that
I had previously verified and recorded on FCC’s books. He then deleted
the liabilities from the general ledger. I told Richard that I could
not be involved in this activity and left the office before he finished
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deleting the liabilities from the general ledger. I learned later that he
had instructed the accounts payable clerk to assist him after I left and
together they deleted most of the liabilities.
FCC never did get a bank loan, but was not forced into bankruptcy by its
creditors either. Over the next few months FCC slowly went out of business.
Rather than file for bankruptcy protection, FCC simply ceased operating
under its current name and reemerged under a new name. No one at FCC
was ever charged with fraud. I heard through the grapevine that Richard
had used several million dollars of his personal money to pay some of
FCC’s subcontractors and vendors. However, some did not get paid any-
thing and others did not get paid in full.
Richard did not satisfy his existing bank loans before going out of busi-
ness, and these loans totaled more than $1 million. I believe the banks did
not force FCC into bankruptcy because they wanted to give the company
every opportunity to pay its debts. As long as FCC stayed in business the
banks had some hope of being paid.
FCC was able to complete its existing highway construction contracts
before going out of business and sought small paving and excavation jobs
while it was wrapping up those contracts. However, FCC was unable to per-
form enough small jobs to meet its current liabilities and debt service costs,
and this apparently contributed to its decision to close.

QUESTIONS:
1. Describe shortly how does fraud occur in the Case?
2. What do we learn from the Case?
3. What are your recommendations to Prevent the similar case?