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A Company Poised for Change

By Mark Zettlemoyer, CPA, CFE Reinsel Kuntz Lesher LLP

Local governments are entrusted with the custody of public funds, and residents depend on officials to deploy resources responsibly to provide critical municipal services. Your borough likely has safeguards in place to defend funds from outside theft, but protection from inside threats is just as important.

Fraud is a pervasive and univer-sal problem – one that is usually concealed, difficult to detect, and often involves collusion and false documentation. According to the Association of Certified Fraud Examiners (ACFE), the typical organization loses 5 percent of revenues each year to fraud. The information is not meant to cause anxiety, but rath-er to help you acknowledge this risk and empower your borough to detect fraud and mitigate the risk to operations.

Every organization has unique fraud risk factors, and local governments are no exception. In fact, ACFE research shows that government and public administrations are among the sectors with the highest incidences of fraud cases. It is important to understand that fraud can mean more than just stealing money. Occupational fraud occurs anytime someone uses their job for personal en-richment through the deliberate misuse or misapplication of an organization’s resources.

In the vast majority of cases, fraudsters are first-time offend-ers. However, many frauds go unreported because organiza-tions want to avoid negative publicity. According to ACFE, the tenure of the offender most often falls between one and five years of employment. As one

COVER STORY

PENNSYLVA

NIA

STATE ASSOCIATIO

N O

F BO

ROUGHS

The idea that fraud can happen within

your municipal office can be hard to

swallow, particularly for public officials who have worked

together for many years.

Protecting Public Funds

Recognize, Detect, and Prevent Fraud

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might suspect, ACFE research shows that 40 percent of fraud is conducted by personnel in the accounting or operations departments. The more access an employee has to sensitive or financial information, the easier it can be to commit fraud.

The idea that fraud can happen within your municipal office can be hard to swallow, particularly for public officials who have worked together for many years. The hard facts, however, are that most fraud is carried out by those we trust and that given the convergence of negative factors, most individuals could become fraudsters. It is only logical that many fraudsters are the very individuals you trust the most. If you didn’t trust someone, why

would you give him access to your resources in the first place?

Understanding who is most likely to commit fraud is one important step, but it is also crit-ical to understand why someone would steal resources. The Fraud Triangle, developed in 1953 by Donald Cressey, suggests that when three factors – pressure, perceived opportunity, and ra-tionalization – align, fraudulent behavior can occur. Let’s take a closer look at these factors.

Pressure. The potential offender is motivated to act by a financial or personal problem believed to be non-shareable and too great to overcome through legitimate means. Examples in-clude high personal debt, gam-

bling, or dependency habits, or undue family or work pressure.

Perceived opportunity. The perceived certainty of detection is inversely related to the theft. The fraudster must see a way to abuse his position of trust to solve a personal financial problem with a low perceived likelihood of getting caught.

Rationalization. As men-tioned earlier, most are first-time offenders who do not see them-selves as criminals, but rather or-dinary people caught in a bad set of circumstances. Fraudsters often justify their crimes based on per-ceptions of economic inequities, or workplace mistreatment, or even go so far as to consider it a loan they will eventually pay back.

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When planning or executing a fraud, perpetrators may begin to exhibit some behavioral changes, such as habitual tardiness, exces-sive Internet browsing, bullying or intimidation of coworkers, living beyond their means, or failure to use vacation time. These behaviors can be indica-tors of deceitful actions, so em-ployers must remain watchful.

There are also several pieces of physical evidence that can be red flags for fraud. If you see significant differences between subsidiary and general ledgers, notice that documentary evi-dence is unavailable, or find that only photocopies are available where original records should be, it could be a sign that fraud is tak-ing place. The average amount of time from when fraud starts until it is detected is approximately 18 months, so it can be costly and destructive to be unaware of the signs of potential fraud.

According to ACFE, the lack of internal controls is the leading factor that makes an entity vulner-able to fraud. Other factors that create windows of opportunity for wrongdoing include the lack of management review and over-sight, unauthorized or unchecked access to assets by employees, weak processes and procedures, a high number of cash or asset entry points, or a significant amount of cash transactions conducted by staff. It is important to consider whether any of these exist in your municipal office.

Occupational fraud is a very broad concept, but it primarily

falls into three categories: asset misappropriation, corruption, and financial statement fraud. Many cases feature a perpetrator using more than one method to commit the crime – some of the top forms are billing, check tampering, payroll or expense reimbursements, and skimming. Let’s go into a bit more detail about how these are carried out, red flags to watch for, and sug-gested prevention methods.

BiLLiNG SCheMeS

How it works. Examples in-clude the use of shell companies, submission of false invoices for payment, generation of false pur-chase orders, use of incorrect pay-ments to request returned checks, or personal purchases made with public funds or credit cards.

How to detect it. Ongoing scrutiny of vendor lists, purchase orders, and invoices can help root out duplicate payments or billing problems. It’s also important to reconcile the accounts payable ledger to the general ledger, to compare actual expenditures to your budget, and to request and review monthly statements from vendors.

How to prevent it. Segregate duties between au-thorization, purchasing, receiv-ing, and accounting functions when possible. Undertake a thorough review and ongoing monitoring of receiving re-ports, purchases and inventory levels, vendor authorizations,

and payment codings in your accounting records.

CheCk TAMPeriNG

How it works. Examples include concealed checks, forged endorsements, changed payee names, or other alterations to information on the check face.

How to detect it. Review all voided or canceled checks, scrutinize checks payable to em-ployees, and verify supporting documentation for outstanding checks. Following up on vendor complaints for late payments and questionable payees or addresses may also help detect unusual behavior.

How to prevent it. Dis-tinct separation of duties in the accounts payable department can help reduce the opportunity for check tampering. Make sure someone independent of the cash disbursement and purchas-ing functions opens and reviews monthly bank statements and cleared transaction lists. Other strategies include ensuring all checks are mailed immediately after signing, requiring dual sig-natures on checks, and storing unused checks in a secure area requiring dual access.

SkiMMiNG

How it works. Examples in-clude unrecorded or understated revenues, stolen checks, and altered account statements.

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How to detect it. Revenue account analysis, review of jour-nal entries, and control of inven-tory type items can help detect skimming activity.

How to prevent it. Limit access to the general ledger, require review and approval of journal entries, add phys-ical safeguards to assets, and conduct independent reconcil-iation of accounts. Another tip is to have someone indepen-dent of the accounting function open incoming mail and place restrictive endorsements on checks received immediately upon opening.

PAyroLL or exPeNSe reiMBUrSeMeNTS

How it works. Examples include falsified or overstated documents like time sheets or expense reports, or the contin-ued payment of former employ-ees (“ghost employees”).

How to detect it. Analysis of payee addresses or direct de-posit account numbers, expense accounts, and reimbursements can identify inconsistencies. It may be useful to conduct comparisons of current payroll records versus past and present personnel files.

How to prevent it. Insti-tute a more thorough process for expense reimbursements, including requiring original sup-porting documentation. Another best practice is to restrict access

to blank checks and the ability to set up direct deposits.

What else can borough officials do to mitigate the risk of fraud? The most cost-effective way to deal with fraud is to prevent it. In addition to the specific steps listed above, there are some gen-eral controls that can be institut-ed to help deter fraudsters.

First, written policies and pro-cedures must be established, practiced, and enforced through-out the borough. This includes a code of conduct and a fraud policy, which should specifically define acceptable and unaccept-able behavior for all employees. These policies should require reporting by employees who suspect or notice behavior that violates procedures. According to ACFE, tips are consistently the most common fraud detection method – twice as high as the detection rates from manager or internal reviews. Setting up a dedicated fraud hotline can help those who wish to volunteer information discreetly.

Next, take action against identi-fied weaknesses. A comprehen-sive review for fraud exposure is something that may be worth-while. This analysis will produce an inventory of fraud risks that outline what could go wrong, what has occurred in the past, how ready you are to prevent or catch fraud, and how equipped you are to recover from fraud. Recommended steps may in-clude requiring routine monitor-

ing and independent reconcil-iation of accounting functions, restricting access to appropriate staff levels, and requiring sys-temic password modifications for security.

When implementing strategies to protect your municipal office from fraud, nothing is more important than communication with employees and a good example set by leaders from the top down. Establishing a culture that does not tolerate deception and values open communication helps to set the proper tone and keeps the entire team vigilant against fraud. (B)

About the Author: Mark S. Zettlemoyer, CPA, CFE, is a Partner in Reinsel Kuntz Lesher (RKL) LLP’s Audit Services Group. Mark has nearly three decades of public accounting experience serving local governments, not-for-profit organizations, and a broad range of corporate clients. He also leads RKL’s Government Industry Services Group. In addition to being a Certified Public Accountant and Certified Fraud Examiner, Mark served for seven years on the board of a municipal authority and has served as a township supervisor, experiences which provide him insight into the unique challenges local governments face.

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