When one thinks of fraud, the corporate sector is typically the segment of the economy that first comes to mind. Fraud schemes at Enron, WorldCom and other companies have grabbed the headlines during the last decade, and in the process they have cost investors billions and resulted in major accounting overhauls, including the adoption of the Sarbanes-Oxley Act. So, it might be surprising to learn that the government sector actually ranks second in terms of the frequency of fraud, behind only the banking and financial services industry, according to the Association of Certified Fraud Examiners’ “2008 Report to the Nation on Occupational Fraud.” This fact is alarming considering that, unlike corporations, governments do not exist to make a profit but to exercise a fiduciary responsibility over taxpayers’ money. No one wants their money to be stolen, and undoubtedly most taxpayers will feel their money has been stolen if their local government falls victim to fraud.
TYPES OF FRAUD
Fraud can be as minor as a theft of office supplies or as serious as defrauding investors and creditors through elaborate accounting schemes. Fraud may be classified into three broad categories: asset misappropriation, fraudulent financial reporting and corruption. Asset misappropriation usually involves misappropriation of cash, either through outright theft, skimming of cash receipts, or fraudulent cash disbursements. However, asset misappropriation also can involve non-cash assets, such as computers, vehicles or inventory.
Governments are exposed to the risk of each of these types of fraud. However, according to the ACFE study, two specific types of fraud account for more than 50 percent of the instances of fraud within the government environment: billing schemes and corruption. Billing schemes occur when a government pays invoices an employee fraudulently submits to obtain payments he or she is not entitled to receive. Versions of billing schemes include the creation of a shell company or ghost vendor, purchasing a product with government funds and returning it for a personal refund, or charging personal purchases to the government. Common warning signs for these schemes include increasing “soft” expenses, vendors with PO Box addresses, vendors listed as initials, and excessive voided or missing checks. Given the extensive amount of goods and services purchased by governments from external vendors, governments would be prudent to keep these warning signs in mind. According to the ACFE study, billing schemes generally end up being the most expensive type of asset misappropriation frauds.
Corruption occurs when government employees or officials accept bribes, illegal or inappropriate gratuities, kickbacks or excessive gifts or when government employees or officials experience conflicts of interest. In the state and local environment, corruption schemes are made possible by the fact that most governments award service contracts through a competitive bidding process. The official supervising the process could be tempted to accept a bribe or kickback from a bidder in exchange for awarding that vendor a contract. Ultimately, corruption schemes cause governments to overpay for services (since the lowest bidder would likely have been selected had corruption not taken place), thus benefiting the perpetrator at the expense of taxpayers.
WHEN FRAUD OCCURS
During the past year, stock prices have plummeted, the housing market has collapsed, and the economy has faltered. The ripple effects from these events have caused significant financial difficulties for many people. Accordingly, the temptation for employees to commit fraud schemes as a quick way of getting cash has increased significantly.
This financial pressure to commit fraud is one of the three components of the “fraud triangle,” along with rationalization and the perceived opportunity to commit fraud. These three components are present in every fraud. While pressure and rationalization are largely out of a government’s hands, governments do have the ability to reduce perceived and actual opportunity.
HOW FRAUD IS DETECTED AND DETERRED
The ACFE study found that fraud is detected six ways: through tips, accidents, internal audits, internal controls, external audits and when governments are notified by police. Obviously, reliance on the police or accidents to uncover fraud is not advisable. Additionally, financial statement audits are not designed to detect fraud, and of all fraud schemes that are ultimately uncovered, only 2 percent are uncovered as a result of a financial statement audit. Thus, the most effective ways for governments to detect and deter fraud are developing strong internal controls, performing internal audits and promoting employee tips.
STRONG INTERNAL CONTROLS
According to the ACFE study, 20 percent of fraud schemes that were uncovered were initially detected though internal controls. Management needs to design controls to provide assurance that fraud objectives are being met. This process starts with operations that are routine in most governments, such as preparing monthly bank and account reconciliations. It is imperative that these controls are performed in a timely manner in order to function properly.
Effective controls surrounding check processing also are essential for every government. In general, there should be a segregation of duties for the approval, processing and signing of checks, as well as the reconciliation of bank statements. All checks over a dollar threshold should be manually signed by two employees from outside of the finance department. These steps alone greatly decrease the chance of billing schemes going undetected. The government also should invest in check stocks that cannot be scanned or easily manipulated.
Governments also can take advantage of their bank’s positive pay system, a common devise used to eliminate check fraud. Under such a system, the government’s finance department submits its check register daily to the bank through a secure online process. The bank then only clears checks that match the check number, payee and amounts submitted by the government.
When a government receives a significant number of check payments through the mail, it may be wise to establish a lockbox with the bank to mitigate fraud. Under a lockbox system, receipts are mailed directly to the government’s bank, where they are tracked and deposited. This process essentially eliminates the risk that check receipts will be misappropriated. Governments also should obtain fidelity bonds for all employees who handle cash.
Many large governments have a formal internal audit department. While small governments generally find this cost-prohibitive, these governments can still achieve the same objective by creating an internal audit committee, as many small not-for-profit organizations do. Such a committee should be headed by a member of the government’s ruling body or an independent financial expert appointed by the ruling body. The following are procedures that the internal audit committee should perform, as recommended by Edward J. McMillan, CFE:
- Review the prior month’s bank reconciliation detail.
- Ensure that the organization’s internal control policies are effective and, more importantly, being followed.
- Meet with representatives of the bank to review signature cards to ensure that all signers are authorized and that there are no unauthorized accounts.
- Meet with the insurance agent to ascertain that coverage is adequate for all policies, with particular attention to fidelity bonds.
- Test the payroll by comparing payroll records to personnel files.
- Contact each employee directly to ensure that there are no “ghosts on the payroll.”
- Interview all employees who are responsible for receiving and disbursing checks to ensure that policies and controls are adequate and being followed.
- Test disbursements to ensure that invoices have been approved for payment properly.
- Check the accounts payable files and physically contact new vendors to ensure that they exist.
The internal audit committee should report its findings to the governing body and external auditors. Developing an internal audit committee may be a government’s best and, in many cases, only way to determine that internal controls are functioning properly. In addition, the ACFE study noted that 18 percent of uncovered fraud schemes were detected as a result of internal audit procedures.
The ACFE study noted that 50 percent of uncovered fraud schemes in the government sector were initially detected through employee tips. Governments should encourage such tips by developing a formal whistleblower policy. This policy should describe the method in which employees can report fraud without fear of retaliation. In order to make the process more confidential, the government should consider using a third party “whistleblower hotline.” Under such a system, a vendor receives phone calls directly from whistleblowers, logs the information gained from these calls, and reports the issues to the appropriate government official. Whistleblowers may report their tips anonymously if they so choose. For most such hotlines, the costs of implementation and ongoing usage are not significant.
Fraud is prevalent in the government environment, and the current economic crisis has given employees all the more reason to consider attempting a fraud scheme. While the risk that fraud will occur can never be completely eliminated, governments do have an obligation to constituents to minimize this risk to the extent possible. Developing strong internal controls, ensuring an active internal audit function, and encouraging employee tips are the most effective ways of accomplishing this objective.
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