1996 EvaluatingInternalControlsALoca
- (Gauthier & Association, 1996) ⇒ Stephen J. Gauthier, and Government Finance Officers Association. (1996). “Evaluating Internal Controls: A Local Government Manager's Guide.” Government Finance Officers. ISBN:9780891252252
Subject Headings: Internal Financial Controls in Government, Public Sector Fraud.
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Book Overview
An ideal guide for public managers seeking the practical guidance they need to assume a leadership role in the design, implementation, and maintenance of a comprehensive framework of internal controls. The book begins with an overview chapter that puts the entire internal control framework in perspective; chapters then address management objectives and responsibilities; the control environment; risk monitoring and assessment; control-related policies and procedures; information and communication; monitoring; evaluating controls over accounting and financial reporting; and preventing and detecting public-sector fraud. An appendix demonstrates how management can apply the techniques outlined in the book to identify weaknesses and compensating controls in a variety of different circumstances.
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Chapter 9 - Public-sector Fraud: Prevention and Detection
Like managers in the private sector, public-sector managers have a duty of stewardship for the resources entrusted to their care. Indeed, many would argue that public-sector managers have an even higher degree of responsibility for stewardship than do their private-sector counterparts because the resources they administer are obtained involuntarily (i.e., through taxation) rather than voluntarily (i.e., through individual investment decisions). Whatever the case might be, citizens clearly expect managers of public-sector resources to take every reasonable precaution to prevent the misuse or diversion of public funds. Indeed, the press and the public typically are unforgiving toward management when fraud does occur, even when the amounts actually lost by the government are relatively minor.
Causes of fraud
Fraud does not just "happen." Typically, various circumstances combine together to create a situation favorable to fraudulent activity. One factor to be considered is the character and personality of those working for the government. Any of the following situations may predispose a given individual to consider committing a fraud:
· Financial stress. Desperate problems can lead some individuals to desperate "solutions." People facing financial crises (e.g., unpaid medical bills, bankruptcy) may be prime candidates for fraud.
· Addiction. Individuals attempting to support gambling, alcohol or drug "habits" may turn to fraud to help finance their addiction.
· Disaffection. Employees who believe that they have somehow been mistreated (e.g., denied promotions or raises) may be tempted to use fraud to "strike back" against the government or to "get what's due" them.
· Pathologies. There are some rare individuals who are pathologically disposed to fraud, or who may engage in frauds as a type of intellectual challange.1
A second, more important factor is opportunity. Even the most troubled individual cannot commit fraud without the right opportunity. So too, otherwise honest people often have been led to commit fraud simply because the opportunity to do so became "irresistible." Opportunity then, not only permits fraud to occur, but actually promotes it. The "opportunity" needed for fraud is created when management fails to meet its responsibility to establish and maintain a sound and comprehensive framework of internal controls.
1 Intellectual challenge, for example, has been cited as the prime motivating force that has driven a number of well publicized "hackers" to attempt to gain illegal access to various sensitive computer systems.
Cost of fraud
The most visible "cost" of fraud is the diversion of public resources from their intended purpose. There also are other significant costs involved with fraud that are at least as important:
· Loss of confidence in the government. Governments depend upon their taxpayers to obtain the resources they need to provide services. The publicity surrounding public-sector frauds can have a serious negative impact on taxpayers' confidence in their government, and consequently on their willingness to provide additional resources.
· Loss to the reputation of innocent third parties. When a fraud occurs in a given department, a "cloud" often forms over innocent people working in that same department. Thus, people often will falsely assume that others in the department were involved in the fraud, or at least were aware of it. The result is "guilt by association" that can taint the careers of many individuals with no connection to the fraud.
· Cost to the perpetrator. It is only fitting that people who commit frauds be punished for betraying the public trust. Nonetheless, there is an element of tragedy in the punishment that sometimes awaits perpetrators of fraud in the public sector, where relatively small thefts may be widely publicized and result in the loss of reputation, career, family and sometimes even life.
Types of public-sector fraud
The public sector is challenged by many of the same types of fraud as private-sector enterprises. Some of the more common of these frauds are briefly described in the paragraphs that follow.
- Kiting
- Kiting is a classic scheme for "borrowing" funds from a government and then concealing their absence. In ordinary circumstances, the cash balance reported in the accounting records will be different from the cash balance reported in the monthly bank statement. For example, a government's cash balance per the bank's records will include encashed checks, but not amounts "in transit" from the government to the bank. In a kiting scheme, a dishonest employee will attempt to hide the fact that funds are missing by claiming that the amounts are actually in transit between the government and the bank.
- Lapping
- Lapping schemes operate on the principle of "robbing Peter to pay Paul." A dishonest employee with access to both the accounts receivable records and cash collections will "borrow" funds by failing to credit a payment made to an account. This account is then later "reimbursed" when a subsequent payment destined for a second account is, in fact, diverted to "pay off' the first account. This process can then be continued indefinitely. One advantage of lapping is that no single account remains "out of balance" for a long period, thus reducing the chance of detection. Indeed, even if an affected individual happens to notice that an account has not been credited for a payment already made, the individual is more likely to blame "bureaucratic delays" or "computer glitches" than to suspect fraud.
- Bid rigging
- Governments often use competitive bidding to obtain the lowest possible price for needed goods and services. Because of the often considerable sums of money involved, it is not uncommon for unscrupulous individuals to attempt to circumvent the competitive bidding process, a practice commonly referred to as "bid rigging." For example, competing firms may illegally reach an understanding to "take turns" placing the low bid on government contracts, or may agree to divide up a service area so that each colluding firm will always be the low bidder in "its" area. Firms also may improperly agree to "share" a contract by taking on unsuccessful "competitors" as subcontractors.
Still other types of bid rigging require the participation of corrupt government officials. For example, an individual bidder may be informed by someone inside the government that a certain specification will be eliminated from a contract after it is awarded. In that case, the bidder can use this knowledge to "lowball" competitors by including in the bid an unrealistically low price for the specification that will be eliminated. A similar corrupt use can be made of change orders (i.e., contract amendments made subsequent to the award of the contract) if these are known in advance. In the same vein, dishonest government employees can slant specifications to favor a specific firm. In all of these cases, kickbacks from contractors to dishonest government employees may provide the incentive needed for collusion.'
- Payroll fraud
- Governments may be fraudulently induced into paying salaries or wages that have not been earned. For example, "phantom" employees may be placed on the payroll, or supervisors may delay processing termination papers on employees and then keep the checks for one or two pay periods after the employees have been terminated. Another, more subtle form of payroll fraud is to increase artificially the hours worked by retiring employees as a means of inflating their pension benefits (which are often calculated using final salary levels). Other types of payroll fraud involve unnecessary overtime, falsified overtime and unreported leave.
- Healthcare beneficiary fraud
- Healthcare benefits are among the most costly that a government provides to its employees. Sometimes individuals will attempt to cheat on health insurance coverage by listing as beneficiaries individuals who do not qualify (or no longer qualify) as family members.
- False claims
- Governments are sometimes billed for goods or services they did not receive. One particular form of this fraud is to substitute inferior goods for those actually ordered by the government and then bill the government for the higher quality goods.
- Double payments
- Dishonest individuals sometimes try to defraud a government by billing it twice for the same goods or services. One method used for this purpose is to bill for the same item under two separate contracts. Another approach is to seek payment from both petty cash and the regular reimbursement process forone and the same item.
- Charge-off fraud
- A government will "write off" its delinquent receivables after all reasonable attempts have been made at collection. If a single individual has access both to cash collections and to the receivables records, that individual may make an unexpected collection on a delinquent account and then write it off as "uncollectible," thereby removing all evidence of the theft.
- Disposal fraud
- The government alone is entitled to profit from the disposal of its surplus equipment and supplies. Nonetheless, sometimes an employee responsible for disposing of surplus items may become aware of a way to profit from the disposal of which the government itself is unaware. Rather than allowing the government to benefit from this knowledge, the employee may be tempted to make a personal profit. Such an action, however, is fraudulent, because an employee entrusted with the disposal of surplus assets has the fiduciary responsibility to obtain the highest available price for those assets.
2 Kickbacks also can take the less direct form of gifts or favors (e.g., free travel or meals).
- Travel-claim fraud
- Some government employees are required to travel as a part of their job. In such situations, the employee is properly reimbursed for reasonable and necessary travel costs. Employees sometimes are tempted to cheat on travel claims by claiming expenses that they did not, in fact, incur (e.g., meals already provided free as part of a conference program) or by inflating expenses (e.g., claiming excessive mileage). They also may attempt to "reimburse" themselves for unallowable items (e.g., alcoholic beverages) by "running them through" other accounts that may require little or no documentation (e.g., tips and miscellaneous).
- Pilfering
- Pilfering is the petty theft of supplies and similar items of small monetary value. Because the cost of controls should not exceed their benefits, a certain amount of pilfering is unavoidable. However, pilfering can easily "get out of hand," especially in larger governments. What may begin as the occasional chance removal of a few pens or a tablet can easily escalate, if left unchecked, into a large-scale diversion of supplies.
- Misuse of assets and services
- Like pilfering, the small-scale misuse of assets and services by employees can quickly escalate. Common examples of such misuse of government assets and services include nonbusiness-related telephone calls, copying, faxing and use of computers and electronic mail.
- Petty cash fraud
- Custodians of petty cash funds sometimes illicitly "borrow" from the resources of those funds. One method used to conceal such thefts is to include an adding machine tape along with the receipts in the petty cash box. This adding machine tape will show an amount for each receipt. Moreover, the total shown on the tape, when added to the cash still in the box, will equal the amount that is supposed to be in the petty cash fund. However, the total on the adding machine tape only produces the "correct" amount because there originally was another number at the top of the tape (i.e., an amount equal to the "borrowing") that was subsequently removed. If the individual reimbursing the petty cash fund relies on the total printed on the adding machine tape rather than readding the amounts, the theft may go undetected.
Fraud Prevention
The only effective response to fraud is prevention, and prevention requires a sound and comprehensive internal control framework. Indeed, as noted earlier, poor internal controls do not just permit fraud to occur, they actually encourage it.
A few examples taken from the frauds discussed above may be useful in showing the important role internal controls can play in stopping fraud before it happens.
• Properly designed records. Duplicate payments for the same goods or services are unlikely to occur if payment is only made based upon original documentation that is subsequently stamped or perforated to prevent reuse.
· Segregation of incompatible duties. Charge-off fraud cannot occur (absent collusion3) if cash collections are kept separate from the accounts receivable function. Similarly, lapping is dependent upon access to both cash collections and receivables records.
· Periodic reconciliations. Regular, timely and independently performed bank reconciliations are sufficient to prevent kiting.
· Periodic verifications. Unauthorized "borrowings" from petty cash funds and "phantom employees" can be kept in check or prevented by surprise inspections.
· Analytical review. The reasonableness of travel claims can be established by making appropriate comparisons with similar past trips. Likewise, an independent analysis of supply needs can disclose unacceptably high levels of pilferage.
It should be noted from some of the examples just given that even controls that are designed to detect fraud after it occurs (e.g., periodic verifications and analytical review) can also be highly effective in preventing its occurrence. That is to say, the knowledge that detection and exposure will be swift and certain is a powerful disincentive to fraud. Thus, educating employees at all levels about the purpose and operation of internal controls can itself help to discourage fraudulent behavior, just as a highly visible "cop on the beat" can deter crime.
Fraud Detection
Fraud detection is no substitute for fraud prevention. Nonetheless, because no system of internal controls is fool proof, management must be prepared to detect fraud when it does occur.4 Unfortunately, there is no systematic way to ensure that all instances of fraud will be detected. Nonetheless, the following guidelines can significantly increase the likelihood of detecting fraud when it does occur:
· Remember that anyone can commit fraud. It is true that some individuals are more predisposed to commit fraud than others. Nonetheless, with sufficient opportunity almost anyone may be tempted to steal. Indeed, many individuals get trapped in easily detected frauds precisely because they are convinced that they are just "borrowing" funds temporarily and will be able to return the money in time to avoid detection. There is no bigger error than to think that "only thieves" steal.
· Do not dismiss tips, even when obtained from hostile sources. In practice, tips are the single most important means of detecting fraud.5 Sometimes, tips are provided by honest individuals who believe it is their ethical duty to report a fraud, or who fear they may be implicated in the fraud if they fail to report it. Often, however, the motive for providing a tip may be considerAily less praiseworthy. For example, a jealous employee who was "passed over" for a promotion may offer incriminating information on a co-worker who was promoted. Likewise, a former husband or wife may volunteer information on fraudulent activities. involving their ex-spouse. Just because a person's motives are questionable, however, does not mean that the person is not telling the truth. Accordingly, all tips should be investigated if it appears they could have a reasonable basis in fact.6
3 It will be recalled that collusion occurs when two or more employees who are to act as a control on each other cooperate instead to circumvent controls.
4 It will be recalled from an earlier discussion (chapter 1) that there are a number of inherent limitations on any system of internal controls. Thus, it is not practical to implement every possible control because the cost of controls should not exceed their benefits. Likewise, dishonest employees can collude to circumvent controls. Also, there is the chance that management may be tempted to "override" the very controls that it has set in place.
5 Because of the importance of tips in fraud detection, a number of governments have established "hot lines" where citizens wishing to report fraudulent or suspicious activities may do so anonymously.
· Use analytical review to identify !potential problems. One of the best ways to find fraud is to look for situations where actual results differ from what might reasonably have been expected in the circumstances. For example, management should rigorously investigate significant budget variances.
· Carefully examine unusual transactions. The demands of bookkeeping sometimes force individuals committing frauds to record sham "transactions" to conceal the diversion of resources. Management should be on the lookout for "unusual" transactions and demand a thorough explanation and supporting evidence. In particular, management should demand a thorough justification for all adjusting journal entries.
· Carefully examine supporting documentation. When examining transactions as part of its testing of control-related policies and procedures over accounting and financial reporting, management should carefully examine all supporting documentation. In the case of checks, for instance, the following occurrences may indicate a potential problem:
— Checks made payable to "cash,"
— Checks made out in even amounts for sums over $100,
— Checks made out to vendors that were cashed rather than deposited,? — Nonpayroll checks endorsed by hand.8
Likewise, invoices possessing any of the following characteristics may indicate a potential problem:
— Invoices with only a post office box number,
— Invoice numbers that are typed rather than printed,
— Invoices with a heading that is rubber-stamped rather than printed,
— Invoices that do not provide a telephone number,
— Invoices for goods or services of a type not normally provided by the
vendor (e.g., an invoice for hardware from an office supply firm).
The goal in examining documentation should be to target factors that are unusual or unexpected and then to pursue explanations. Indeed, the very absence of normal flaws (e.g., typos, erasures, wear and tear) in documents can itself be an indication of potential problems.9
6 Tips should be distinguished from mere speculation or conjecture. Thus, the first question to be asked of someone offering a tip is "how do you know that what you are saying is true?" Does the informant have direct personal knowledge of the fraud (e.g., "I saw him do it"; "I saw crates of city supplies in his garage")? Has the person obtained information from someone with direct personal knowledge (e.g., "one of his coworkers told me that she saw him do it")? Or is the informant simply passing on vague rumors (e.g., "everyone in the department knows he's a thief"). While a mere rumor should put management on its guard that there may be a problem, it does not, of itself, necessarily justify a full investigation.
7 It is ordinary business practice to deposit all checks intact and then to make withdrawals separately.
8 It is ordinary business practice to use a stamp to endorse all checks as received.
9 For example, the document may not have been subjected to normal wear and tear because it did not actually go through the regular approval process.
It is important to note that the presence of a potential fraud indicatoe° does not necessarily mean that a fraud has actually occurred. Rather, fraud indicators serve simply as "red flags" to alert management to situations where there is a higher than average chance that fraud may have occurred. Only a thorough investigation can resolve whether a fraud actually did occur.
Investigating Fraud
It is management's responsibility to investigate thoroughly any indications that a fraud may have occurred. However, because every investigation of a possible fraud could potentially result in a prosecution, it is extremely important that management conduct its investigation in such a way as to avoid any chance of hampering an eventual prosecution. The first step is to obtain professional legal help ." With the benefit of legal advice, management should then keep within the following guidelines in conducting any portion of the investigation:
· Maintain objectivity. The goal of any investigation should be to uncover all of the relevant facts. If investigators focus their efforts solely on gathering incriminating material, the information they collect may be deemed inadmissable in court, where the standard is not just "the truth," but "the whole truth."
· Seek out the "best evidence." Management should obtain original documents whenever possible." If not, the official custodian of the document should make a copy for management and write "true copy" on its face. It is important to explain in writing why it was impossible to obtain the original document if that is the case.
· Obtain documents onlyfrom official custodians. It is important that records not be obtained improperly. Accordingly, care should be taken to address any requests for documents to the official custodian of the documents.
· Maintain a "chain of custody" over potential evidence. If a fraud is eventually prosecuted, the court will insist that management prove that any incriminating evidence was not tampered with subsequent to its collection. That is to say, management will have to be able to indicate precisely who had responsibility for the evidence at any given moment from the time of its collection until the trial. Management also will need to be able to indicate the safeguards that were in place to ensure that unauthorized individuals could not gain access to the evidence during that time.
Exercise care in conducting interviews. Always conduct interviews with at least one other individual present. A consistent note-taking policy should be followed for all interviews (i.e., do not take notes of some conversations, but not of others).13 Notes should be made either during the-interview or immediately thereafter (i.e., not three days from now or next wee). Management should resist the temptation to "fill in" silences, and instead should allow the person being interviewed to do most of the talking. The interviewer also should be careful to assume nothing, but rather to ask the person being interviewed to clarify any potential ambiguities (e.g., "What do you mean exactly when you say that X was in on it'"?). One good technique to avoid potential misunderstandings is for the interviewer to restate or summarize periodically what the person being interviewed has just said.'4
10 A "fraud indicator" is any circumstance or set of circumstances that signal a greater than ordinary chance that an irregularity may have occurred.
11 Indeed, most or all of a typical fraud investigation will be conducted by someone other than management.
12 If an original document is to be removed from the records, the custodian of that document should make a copy to replace the original and write "true copy" on its face.
13 This rule applies equally to telephone conversations.
· Retain all written records. All written records of the investigation, including original notes of conversations and drafts, should be retained.
· Discuss the investigation onlyrwith competent authorities. It is extremely important that the good reputation of employees be protected. Accordingly, progress on an investigation -should only be discussed with those who have a professional "need to know," and only upon the advice of legal counsel.'5
When an investigation discloses that an irregularity has, indeed, taken place, management must then attempt to determine the full extent of the fraud. Who was responsible? What was stolen? When did the fraud begin and how long did it last?
One useful way to identify potential participants in a fraudulent scheme is to ask the additional question "who else should have known about the fraud?" Likewise, when determining what was taken, it is a good idea to ask "what else could that same individual have stolen?" Individuals have been known to confess willingly to small frauds (once they have been uncovered) to deflect attention away from larger fraudulent schemes that still remained undetected. Finally, discovering the motivation for the fraud may be useful in helping to "pin down" dates. If the fraud is blamed on medical bills, for example, then the fraud should not have preceded those bills. Once again, dishonest individuals may volunteer information on a starting date for the fraud to conceal even larger thefts that may have occurred before that date. Accordingly, management should examine at least a brief period prior to the alleged starting date of the fraud to verify that the fraud had not, in fact, begun at some earlier date.
- Prosecution
Those who abuse the public trust by stealing or otherwise misusing public resources deserve to be punished. Unfortunately, management sometimes does not elect to pursue the prosecution of "white collar" criminals, but instead will satisfy itself with restitution and the dismissal of the offending employee in an effort to avoid adverse publicity. This approach is unsatisfactory for several reasons. First, it is the role of the district attorney and of the courts (not management) to decide on the appropriate punishment for those who have broken the public trust. Second, management may expose itself to severe public criticism if the details of such an arrangement become public (which is counterproductive if management desires to avoid "negative" publicity). Third and most important, the public punishment of those who commit fraud can serve as a strong disincentive to those who might otherwise be tempted to pursue the same path, thus reinforcing the government's control environment.
- Summary
Citizens expect managers of public-sector resources to take every reasonable precaution to prevent the misuse or diversion of public funds. A variety of conditions can come together to predispose individuals to commit fraud (e.g., financial stress, addiction, disaffection, pathologies). However, even otherwise honest employees can be tempted to commit fraud if provided with sufficient opportunity. Therefore, it may fairly be said that opportunity not only permits fraud to occur, it actually promotes it.
14 It is particularly important to seek legal advice before interviewing someone who is suspected of fraud.
15 Discussing a fraud investigation inappropriately can result in significant potential legal liability for the government.
There is a high cost to public-sector fraud, even beyond the diversion of funds. Publicity surrounding fraud may reduce taxpayers' confidence in their government, as well as their willingness to support it financially. Also, innocent third parties often are victimized by the "cloud" that frequently hovers indiscriminately over all those who work in an office or department where fraud has occurred. Finally, the publicity surrounding even relatively minor public-sector frauds can create disproportional personal tragedies for the perpetrators.
The types of fraud found in the public sector are often similar to fraudulent schemes found in the private sector. These include kiting, lapping, bid rigging, payroll fraud, healthcare beneficiary fraud, false claims, double payments, charge-off fraud, disposal fraud, travel-claim fraud, pilfering, misuse of assets and services, and petty cash fraud. The only effective response to these and other types of fraud is prevention, and prevention requires a sound and comprehensive framework of internal controls. It is noteworthy that even controls designed to detect fraud can actually help to prevent it from occurring, just as the visible presence of a "cop on the beat" can deter crime.
Because of inherent limitations in any system of internal controls, management must be on the alert for situations that could indicate the presence of fraud. Management can improve its chances of detecting fraud by remembering that anyone can commit fraud, by following up on tips, by performing analytical review procedures, by carefully examining unusual transactions and by carefully examining supporting documentation.
It is important that management obtain legal assistance before investigating potential fraud. Also, throughout the course of any fraud investigation, management should strive to maintain its objectivity, to seek out the "best evidence," to obtain documents only from official custodians, to maintain a "chain of custody" over potential evidence, to exercise care in conducting interviews, to retain all written records and to discuss the investigation only with competent authorities.
Finally, once it has been discovered that fraud has occurred, management must seek to determine the full extent of the fraud. Questions that should be asked include "Who else should have known about the fraud?," "What else could the same individual have stolen?," and "Was there any external motivation for the fraud (e.g., financial difficulties) that might help to pinpoint the starting date?" Likewise, management should pursue the prosecution of those who commit fraud to strengthen the government's control environment.
References
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| Author | volume | Date Value | title | type | journal | titleUrl | doi | note | year | |
|---|---|---|---|---|---|---|---|---|---|---|
| 1996 EvaluatingInternalControlsALoca | Government Finance Officers Association Stephen J. Gauthier | Evaluating Internal Controls: A Local Government Manager's Guide | 1996 |