Fiduciary Responsibility, Fraud, and Internal Controls

1. Fiduciary Responsibility, Fraud, and Internal Controls Presented By Larry Bailey, ARM, CSP

3. Someone You Trust • Church Treasurer • Deacon Board • Leader in Professional Association • PTA Board President

4. Why? • Role of Self Deception • Procrastination • Rationalization

5. The “Fraud Triangle” Motive/Pressure Opportunity Rationalization

6. Catching the Office Manager The Obscured Invoice

7. Isn’t it the Auditor’s jobto Find Fraud? Are you assuming too much?

8. Auditor’s Role • “Expectation Gap” • Public assumes purpose of the audit is to catch fraud. • Statement on Auditing Standards 99 (AICPA Acct Stds Bd) • “The auditor has responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” • Auditors prepare report on whether the financial statements are fairly presented. They should investigate suspected frauds uncovered during their review, but not primary objective.

9. How Much Fraud Is There? • Association of Certified Fraud Examiners (ACFE) Annual Report (www.acfe.org) • 1,843 cases surveyed Jan08-Dec09 (40% outside US) • Average loss 5% of annual revenue • Median Loss $160k, 25% > $1m • Financial Statement Fraud $4.1m, Corruption $280k, Asset Misappropriation $135k • Asset misappropriation cases most common 90%, Corruption 22%, Financial Statement Fraud 4% (Overlap because many cases involve more than one) SOURCE: 2010 ACFE Annual Fraud Report

10. Who Commits Fraud? • Employees 42% (median loss $80k) • Managers 41% (median loss $200k) • Executives 17% (median loss ($723k) SOURCE: 2010 ACFE Annual Fraud Report

11. Gender & Age of Fraudsters • Men 57% • The median $ loss is 2.5x women • 40% have between 1-5 years seniority • The longer they have worked there, the bigger the average theft • 50% between ages 31-45 • Losses sharply increase with age SOURCE: 2010 ACFE Annual Fraud Report

12. Fraudster’s Departments • Accounting 22% • Sales 14% • Upper Management 14% • Purchasing 6% • IT 3% • HR 1.3% • Internal Audit 0.2% SOURCE: 2010 ACFE Annual Fraud Report

13. Fraudsters Records • 87% had no previouscriminal record • 83% never punished or terminated from earlier job SOURCE: 2010 ACFE Annual Fraud Report

14. How Long Does Fraud Last? • Median time before detection 18 months • Two fraud cases in Water & Sewer Special Districtswent on for 6-7 years SOURCE: 2010 ACFE Annual Fraud Report

15. How Did They Do It? • Missing/Weak Internal Controls (37.8%) • Override of Good Internal Controls (19.2%) • Lack of Management Review (17.9%) • Poor “Tone at the Top” (8.4%) • Incompetent Oversight (6.9%) • No Independent Oversight (5.6%) • All Others (4.2%) SOURCE: 2010 ACFE Annual Fraud Report

16. How Do Managers Think Fraudis Detected? • External Audit – 76% • Internal Audit – 69% • Fraud Training - Managers – 42% • Fraud Training - Employees – 40% • Job Rotation/Mandatory Vacations – 15% SOURCE: 2010 ACFE Annual Fraud Report

17. How is Fraud Actually Detected? • Fraud Tip Line (40.2%) • Management (15.4%) • Internal Audit (13.9%) • Accident (8.3%) • Account Reconciliations (6.1%) • Document Review (5.2%) • External Audit (4.6%) SOURCE: 2010 ACFE Annual Fraud Report

18. Warning Signs • Living beyond means (30%) • Financial difficulties (20%) • Control issues (15%) • Close with vendors/customers (10%) • “Wheeler-dealer” style (5%) • Divorce/family issues (5%) • Addictions (5%) • Never takes vacations (5%) • Frequent complaints about pay/promotions (5%) SOURCE: 2010 ACFE Annual Fraud Report

19. Three Steps to a Fraud • Commit-Take the money, create the false vendor, etc. • Perception of effective internal controls is best way to stop this. • Conceal-Alter records to make detection difficult • Effective internal controls make hiding the fraud more difficult • Convert-Alter the form of what has been taken into something useful to the fraudster • Conversion can be internal (check for cash) or external (eBay?)

20. Magic Anti-Fraud Bullet:Segregation of Duties • When one person can perform any two of the following, there it’s a fraud opportunity: • Custody Function • Who actually handles the cash, stuff, etc.? This includes the City/Town checkbook. • Approval • Who approves the use or transfer of the asset? • Recording/Reconciliation • Who records the use or transfer? Who prepares the source documents?

21. Types of Fraud • Theft of assets (generally cash, but could be equipment/inventory) • Most common, but lower in total amount • Improper expenditures (fake vendors, “ghost” employees) • Less common, but larger • Financial Statement

22. Cash Receipts Frauds • Is all money getting to bank when it should, and are all adjustments valid? • Skimming/underreporting (before entering system) • Cash theft (receipts already recorded in accounting system) • Ways money comes in? • Mail, credit cards, wire, cash receipts at the counter, etc.?

23. Preventing Cash Receipts Fraud • Segregation of duties • Handlers of cash should never be able to adjust accounts • Separate tills (can be a challenge) • Use receipts that are difficult to alter (pre-numbered, Z-Tapes, etc.) • Daily deposit of ALL funds (State law usually requires) • Even if you don’t know why you got it, accounting can figure it out later • Daily reconciliation of deposit to CR records • Composition of deposits (Does check/cash composition match what the bank received?)

24. Are you getting the benefit of all your purchases? • Small and attractive items • Theft of inventory • Borrowing of equipment • Disposal of “Surplus” or “Damaged” equipment

25. Preventing Misappropriation Frauds • Internal Controls • Separate approval of purchases • Separate approval of write-offs, surplus, scrap • Policy prohibiting personal use of City/Town assets • Tagging the assets • Physical control over inventory/equipment (locked room) • Periodic inventory count • Fraud Hotline (State, Local Govt.)

26. Disbursement Frauds • Do you know where your money is going? • False Billing Fraud • Fake invoices/Fake Vendors • Pay & Return Scheme (Real vendors asked to return “overpayment”) • Kickback Schemes (Vendor actually participates in fraud) • Mileage Expenses

27. Padded mileage expense reports

28. Preventing Disbursement Frauds • Separate person authorizing payment • Original invoice supports expenditure • Documentation supports vouchers • Person who actually knows is the person who approves it • Duplicate payments? • Different person (other than check writer) should do bank reconciliation • Control of payment mailing • Different person mails the payments after they are prepared

29. Payroll Frauds • Are you paying the right people? • “Ghost” employees/PT padded to FT • Right people paid wrong amount? • Padding timesheets • Unapproved raises/benefits • Leave records? • Effectively a raise, since the employee has more vacation as a result

30. Padded time sheets

31. Preventing Payroll Frauds • Internal Controls • Reconciliation of the pay disbursements to the pay records • Who creates and maintains the payroll/records? • Who approves the timesheets? • Can the fraudster alter them after approval? • Who hands out the checks?

32. Financial Statement Frauds • Takes place in the public sector as well • Bond covenants • Grant requirements • Types of Frauds • Concealment of expendituresor liabilities • Improper disclosures • Related parties

33. Preventing Frauds Generally • “What is Tone at the Top” • Organization’s leadership must embrace integrity as a core value of the organization • Truthful reporting more important than favorable reporting • Segregation of Duties • Challenging in smaller entities. Compensating controls must be found

34. Preventing Frauds Generally • Organizational Structure – board member as acting treasurer • Most State Law(s) do not require it (Risk vs. Compliance) • Hiring Practices • Background checks on employees and vendors regarding finance/accounting • Employee Training • All employees are part of the fraud fighting team • Terminate and Prosecute Fraudsters

35. What Can Electeds/GMs Do? • Ask Dumb Questions! • Until you understand the answers. Don’t let accounting’s sophistication intimidate you. (Use Internal Controls Handout) • Review Transactions • Spend an afternoon every few months at the organization office looking at vouchers. Ask more questions.

36. What Can Elected Officials Do? • Listen to Staff • How would they improve their jobs? • Don’t expect to see fraud everywhere, but don’t be afraid to see it either

37. Example of What You Can do • Acting treasurer role – needed for oversight function on every Board “I gave my first treasurer’s report at the boardmeeting last night. I only pretended to know what I was talking about, fortunately, the other board members only pretended that they were listening.”

38. Resources • State Auditor’s Office • State Whistleblower hotline       • State Society of CPAs • Association of Certified Fraud Examiners – http://www.acfe.org • Pool Internal Controls Handout

39. “Trust but Verify”

40. Answers? Larry Bailey larryb@wsrmp.org (425) 952-9750

41. Disclaimer PLEASE BE ADVISED Nothing in the written material shall be considered the legal advice of counsel. Any such questions should be directed to your own legal counsel and professional accounting advisor. The purpose of this material is to help educate employers, employees, and others on how to control risk. The employees of WSRMP assume no liability for any use of this information. This information is considered reliable, but we cannot assume its effectiveness or that all potential risks are addressed. This information does not ensure compliance with federal, state or local regulations. Your use of this information is not a guarantee that losses will be prevented or reduced, nor is this information a substitute for your responsibility to properly administer your internal controls and financial programs.