red flags of municipal fraud: preventing employee dishonesty

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Red Flags of Municipal Fraud

Presented by:

Mary O’Connor, ASA, MRICS

Partner, Valuation and Dispute Advisory Services

Sikich LLP

© 2012 Sikich LLP. All rights reserved.

Agenda

• Distinction between fraud and occupational dishonesty

• Uniform Occupational Fraud Classification System

• Interesting statistics

• Common fraud schemes

• Conducting the investigation

• Systems to prevent employee dishonesty

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Fraud is a much larger legal concept specifically related to a criminal act as

defined in the law. Fraud is both a civil and criminal matter in litigation.

Fraud has four elements:

1. Material false statement

2. Knowledge that the statement was false

3. Reliance on the statement by the victim

4. Damages

Distinction Between Fraud and Occupational Dishonesty


Occupational fraud, also known as employee dishonesty, is the use of employment to commit fraud for personal enrichment through deliberate

misuse or misapplication of employer’s resources and assets.

Distinction Between Fraud and Occupational Dishonesty

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Uniform Occupational Fraud Classification System



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But My Auditor Gave a Clean Opinion

• An unqualified audit opinion does NOT mean that there is no employee dishonesty occurring in the organization

• Employee dishonesty can be significant and the books can still balance

• SAS 99, professional skepticism and materiality


Interesting Statistics

• Losses estimated at twice the annual budget of the US Department of Defense

• Direct correlation between age of fraudster and size of theft

• Direct correlation between job title of fraudster and size of theft

• Overwhelmingly happens in small operations

• External auditors rarely identify fraudulent activity


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Fraud Incidents By Age




Median Loss by Age


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Occupational Position and Fraud




Fraud Incidents By Gender


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Median Loss by Gender




Median Loss per Number of Employees


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Initial Detection of Frauds


Why are municipal governments vulnerable to fraudulent employee activity?

• Denial culture – don’t rock the boat

• No invoice/receivable cycle: revenue as a gift

• Many part‐time employees

• Wink and nod

• Budget constraints

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Who is the fraudster?

• Otherwise honest and responsible citizen

• Computes the likelihood of capture and

believes it is worth the risk

• Tends to be middle‐aged, of either

gender and well‐regarded in the

organization


• Departments with independent systems

• Police: local adjudication

• Cash and cash registers

• Too many bank accounts

• Voucher system

• Reliance on part‐time employees

• Stop payments, outstanding checks

• Sensitive information on desks

• Insecure checks

• Mail handling

• Deposit handling

• Deficient IT system

Fraud Hot Spots

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Red Flags of Municipal Fraud

• Independent IT systems without proper interface

• Poor separation of duties

• Poor internal controls – no one is really looking

• Over‐reliance on certain employees

• Extravagant lifestyles


The Problem with Departmental Systems

Municipalities are composed of numerous sub‐units and many are located remotely from the main office. A manual interface with the departmental system and the Finance Office is a major red flag that requires investigation.

Manual Interface

Dept. System General Accounting System

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The Problem with Department Systems

Departments often run autonomously and many collect significant amounts of cash in total annually. However, the daily deposits to the Finance

Department may be small and seemingly immaterial. Cash theft can easily occur and the entity’s books still balance. Note that theft can occur and the department system can be accurate: the public may not be complaining.



Departments tend to be staffed with insufficient personnel to separate dutiesappropriately. One employee – often working there for years – controls andhandles everything. Management believes that the department just couldn’tfunction without this person.

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The one trusted employee tends to handle, andtherefore can abuse, all the IT passwords so that themalfeasance can be blamed on other employees.



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Common Fraud Schemes

Corruption

• Conflicts of interest

• Schemes with and without vendor knowledge

• Grant fraud

• Bribery and kickbacks

• Bid rigging and procurement fraud

– Use of shell intermediary companies

– Improper use of minority companies

– Multiple names for same vendor

– Different rules for different vendors

– Material substitution

– Change order game



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Financial Statement Fraud

– Fictitious revenues

– Concealed liabilities

– Journal entry fraud

– This is the focus of the external auditor



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Skimming

• Recorded and unrecorded revenue

• Write‐offs of receivables

• Voids and restarts

• Lapping

• Refunds



Fraudulent Disbursements

• Billing: shell companies, pass‐through entities

• Payroll: ghost employees, falsified time record, failure to terminate

• Expense reimbursement

• Check tampering

• Register disbursements: false voids,

false refunds

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Inventory Misappropriation

• False acquisitions and transfers

• Simple theft

• Conversion to personal use


Conducting the Investigation

Goals to this process are:

– Follow‐up on all credible tips and complaints

– Follow‐up on all management letter issues to fraud

– Form a response team that preserves the secrecy of the situation

– Avoid the “Dick Tracy” syndrome

– Create a plan that allows the organization to work together in the future

– Notify Board and management

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Goals (continued):

– Preserve the evidence, especially the computer record

– Deal with the administrative leave and other employment issues

– Deal with employee morale issues

– Keep the place going!!!!

– Work for restitution, insurance claim preparation and possible criminal referral

– Learn from mistakes of the past and fix the problems

– Communicate effectively to the public



Reasons to call in a forensics team

• Preserve the relationship of audit team and staff

• Tasks for the forensics team

– Surveillance

– Proof

– Security of computer evidence

– Interviewing

– Insurance claim

– State’s Attorney support

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A System to Prevent Employee Dishonesty

First and foremost: secure the IT system

– Passwords and encryption

– Laptops and cell phones

– Clean desk policy

– One system among departments

– Sufficient firewalls to prevent hacking



Create a tone at the top

– Clear policies and procedures

– Clear policy of punishment for malfeasance

– Lead by example

– Training, training, training

– Employee background checks and hiring practices

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Install an effective whistle‐blowing system

– Anonymous

– No reprisals

– Off‐site answering service

– Must follow‐up on tips



Internal control system

– Separation of duties

– Authorizations; look at limits

– Computer passwords

– Independent and surprise checks

– Separation of Treasury and Accounting functions

– Think through each system – Where are the holes?

– Rotate and cross‐train

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Alert vendors and install strict controls

– Contract language to include right of audit

– Master vendor file

– Review addresses and relationships

– Physical verification

– Statistical analysis



Secure the physical assets of the organization

– Clean desk policy

– IT policy related to laptops, desktops, phones, iPads

– Checks!!!!!!

– No passwords on computer screens!!!!

– Secure receiving dock

– Semi‐annual inventory of major assets

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Questions?


Mary O’Connor, ASA, MRICS

Partner

Valuation and Dispute Advisory Services

Sikich LLP

123 North Wacker Drive, Suite 1500

Chicago , IL 60606

&

1415 West Diehl Road, Suite 400

Naperville, IL 60563

T: 312.648.6652

M: 708.646.8737

Email: [email protected]

Contact Information

Chad Lucas, CPA

Partner

Sikich LLP

3201 West White Oaks Drive

Suite 102

Springfield, IL 62704

T: 217.793.3363


Stephanie Lombardi, CPA

Partner

Sikich LLP

6815 Weaver Road

Suite 100

Rockford, IL 61114

T: 815.282.6565


red flags of municipal fraud: preventing employee dishonesty

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