Fraud Prevention & Detection for Local Government

Fraud Prevention and Detection
for Local Government
May 19, 2015
Ron Steinkamp, CPA, CIA, CFE, CRMA, CGMA
314.983.1382
rsteinkamp@bswllc.com
6 CityPlace Drive, Suite 900 │ St. Louis, Missouri 63141 │ 314.983.1200
1.888.279.2792 │ www.bswllc.com
2015 MSCPA GOVERNMENTAL
ACCOUNTING CONFERENCE

Session Benefits
© 2015 All Rights Reserved Brown Smith Wallace LLC
What is Occupational Fraud
2014 ACFE Global Fraud Study
Red Flags
7 Keys
Fraud Self Assessment

WHAT IS THE LARGEST MUNICIPAL FRAUD IN US HISTORY?
Question?

City Comptroller (Rita Crundwell) embezzled over $53 million from 1990-
2012.
Facts
• City of 15,000 south of Chicago.
• Home of Ronald Reagan.
• Annual City budget $8-9 million.
Perspective
• Per FBI, 5 months ending February 2012:
- Police - $1.1 million
- Rita’s pocket - $3.2 million
Dixon, Illinois

How did she do it?
• Minimal oversight and small town trust.
• Lack of segregation of duties.
• Opened a secret bank account and transferred in City funds from other
accounts.
• Used funds to pay for her personal and private business expenses.
- Horse farming/ranching operations and shows.
- Personal credit cards.
- Trips
- Real estate.
- Vehicles.
• Fooled the auditors by creating fictitious invoices from State of Illinois.
Dixon, Illinois

How was it detected?
• Comptroller took 12 weeks of approved vacation.
• Interim replacement received bank account and determined
transactions had nothing to do with City business.
Warning signs
• Her lifestyle changed from modest to lavish.
• Inadequate segregation of duties.
Results
• Rita got 20 years in prison.
• Sold off Rita’s Assets
• City of Dixon awarded $40M from lawsuit against the auditors and bank.
Dixon, Illinois

Lessons Learned
• Segregate duties.
• New bank accounts approved by the Mayor and Council.
• Two responsible members of management approve all invoices.
• Payments exceeding a certain amount require two signatures.
• City Council reviews and approves all fund transfers.
• Mayor and Council review and discuss financial reports and audits.
• Anti-fraud orientation provided to all new employees.
• Mandatory annual fraud reorientation for all employees.
• Anonymous fraud hotline.
• Mandatory job rotation.
• Mandatory annual vacations.
• Surprise audits.
Dixon, Illinois

What is Occupational Fraud?

The use of one’s occupation for personal enrichment through the deliberate
misuse or application of the employing organization’s resources or assets.
Three general categories:
 Asset misappropriation
 Corruption
 Financial statement fraud
Definition

Employee steals or misuses an organization’s assets/resources.
- Examples:
• Skimming cash receipts.
• Falsifying voids and refunds.
• Tampering with company checks.
• Overstating expenses.
• Creating a ghost employee.
• Creating a fictitious vendor and false invoice.
Asset Misappropriation

Employee’s use of his/her influence in business transactions in a way
that violates his/her duty to the employer for the purpose of obtaining
benefit for him/herself or someone else.
- Examples:
• Conflicts of interest.
• Illegal gratuities.
• Bribery.
Corruption

Intentional misstatement or omission of material information in the
organization’s financial reports with the intent to mislead.
- Examples:
• Inflating revenues on the financials to show greater profit.
• Concealing liabilities.
• Forcing actual expenditures to match budget by moving
expenses between accounts.
• Improperly accounting for revenues and expenditures.
Financial Statement Fraud

2014 ACFE Global Fraud Study
Report to the Nations on Occupational
Fraud and Abuse

Summary of Findings
1. Typical organization loses 5% of annual revenue to fraud – applied to 2013 Gross World Product
translates to potential fraud loss of more than $3.7 trillion annually.
2. Median loss in the study was $145,000 with more than 22% of the cases involving losses over $1
million.
3. Fraud lasted a median of 18 months.
4. Asset misappropriation schemes (fraudulent disbursements, theft of cash receipts, other asset
misappropriations) were the most common form of fraud, representing 85% of the cases and least
costly at a median loss of $130,000.
5. Financial statement fraud schemes were the least common form of fraud, representing 9% of the
cases and most costly at a median loss at $1 million.

Summary of Findings
6. Corruption schemes fell in the middle, comprising just over 37% of cases and causing a
median loss of $200,000.
7. Occupational frauds are most likely to be detected by tips (40%) followed by management
review (15%) and Internal Audit (14%).
8. Small organizations are disproportionately victimized by occupational fraud.
9. Government/public administration was one of the most commonly victimized
industries.
10. Anti-fraud controls appear to help reduce the cost and duration of occupational fraud
schemes.
11. High-level perpetrators cause the greatest damage to their organizations.

Summary of Findings
12. 77% of frauds were committed by individuals in one of six departments:
• Accounting
• Operations
• Sales
• Executive/upper management
• Customer service
• Purchasing
• Finance
13. More than 85% of fraudsters had never been previously charged or convicted for a fraud-
related offense.
14. Fraud perpetrators often display warning signs – most common behavioral red flag reported
in the survey were perpetrators living beyond their means (36%) and experiencing financial
difficulty (27%).
15. Nearly half of victim organizations do not recover any losses that they suffer due to fraud.

How are Frauds Detected?

Source of Tips

Conclusions and Recommendations
• Occupational fraud is a universal problem – trends in fraud schemes, perpetrator characteristics
and anti-fraud controls are similar regardless of where the fraud occurred.
• The longer frauds last, the more financial damage they cause. Proactive detection methods –
hotlines, management review procedures, internal audits, employee monitoring mechanisms – are
vital in catching frauds early and limiting losses.
• Small businesses/organizations are disproportionately victimized by fraud and under protected by
anti-fraud controls.
• External financial audits are among the least effective controls in combating fraud – primary
detection method of fraud in 3% of cases versus 7% of cases detected by accident.
• Many of the most effective anti-fraud controls are being overlooked – data monitoring and
analysis, surprise audits, fraud risk assessment.
• Majority of fraudsters are first-time offenders – don’t over rely on background checks.

Red Flags

The Fraud Triangle

Pressure “Red Flags”
• High personal debts.
• Living beyond their means.
• Excessive investment speculation.
• Excessive gambling.
• Substance abuse.
• Extra-marital affairs.
• Job frustration.
• Resentment of superiors.

Opportunity “Red Flags”
• Inadequate internal controls.
• Too “cozy” with suppliers.
• Annual vacation or sick days not taken.
• Weak management or excessive turnover.
• Ineffective or no internal audit.
• No rotation of job duties among employees.
• Procedures not well understood/always in crisis mode.
• Large amounts of cash on hand or processed.

Rationalization “Red Flags”
• Not compensated fairly.
• No recent raises/cost of living adjustments.
• Everyone else does it.
• Intended to pay it back.
• Needed the money.
• Felt cheated and wanted revenge.
• Bribe/kickback to tempting.

7 Keys

Anti-Fraud Culture
Fraud Policy
Fraud
Awareness/Training
HotlineAssess Fraud Risks
Review/Investigation
Improved Controls

• Set the tone at the top = Lead by Example
– Responsibility of elected officials and City management
– Behave ethically and openly communicate expectations to employees
– Treat all employees equally
– Zero tolerance
• Create a positive workplace environment
– Focus on employee morale
– Empower employees
– Communicate
• Hire and promote appropriate employees
– Conduct background investigations before hiring or promoting
– Check candidate’s education, employment history, references
– Continuous and objective evaluation of compliance with entity values
– Violations addressed immediately
1. Anti-Fraud Culture

• Code of Conduct
– Formalized and founded on integrity
– Defines acceptable employee behavior
– Communicated to all employees
– All employees are held accountable for compliance
• Discipline
– Sends a strong message throughout the entity
– Should be appropriate and consistent
– Consequences of committing fraud clearly communicated throughout
the entity

• Oversight Process
– City Council/Elected Officials
• Evaluate management’s “tone at the top”, identification of fraud risks and
implementation of anti-fraud controls
• Ensure that management implements anti-fraud measures
• Consider the potential for management override of controls
– Management
• Directs, implements and monitors anti-fraud controls
• Sets the ethical tone
• Trains employees
– Internal Auditor (if available)
• Identifies fraud indicators
• Assesses fraud risks
• Evaluates anti-fraud controls
• Recommends actions to mitigate risks
• Investigates potential frauds

• Demonstrate commitment to combating fraud
• Apply to all Elected officials, City management,
employees, consultants, vendors, contractors, etc.
• Should include:
– Statement of organization’s position on fraud
– Scope of the policy – who does it apply to
– Management’s responsibility for prevention and detection of fraud
– Definition of fraud
– Actions constituting fraud
– Fraud reporting process/procedures
– Fraud investigation process/procedures
– Unit responsible for administration of the policy and investigating fraud
allegations
– Statement on anonymity/confidentiality
– Consequences
2. Fraud Policy

• Reviewed and updated regularly.
• Signed off and agreed to by the City Council/Mayor.
• See the ACFE for an example Fraud Policy
http://www.acfe.com/uploadedFiles/ACFE_Website/Content/documents/Sa
mple_Fraud_Policy.pdf
2. Fraud Policy

• All new employees should be trained at time of hiring
on the Code of Conduct and Fraud Policy.
• Training should include:
– Their duty to communicate certain matters
– A list of the types of matters to be communicated along with examples
– How to communicate those matters
– Affirmation from senior management regarding employee expectations
and communication responsibilities
• Refresher training periodically
3. Fraud Awareness/Training

• Enable employees, vendors, customers and others to
communicate concerns about known or suspected
wrongdoing.
• Telephone, email, internet.
• Anonymous.
• Adequately publicized.
• Internal or External.
• Complaint monitoring and investigation/resolution.
4. Hotline

• Conduct an annual fraud risk assessment.
– Assists management in systematically identifying where and how fraud may
occur and who may be in a position to commit fraud
– Focus on fraud schemes and scenarios to determine the presence of internal
controls and whether or not the controls can be circumvented.
– General steps:
• Identify areas and processes to assess
• Identify potential fraud schemes in each area/process
• Assess likelihood and significant of each scheme
• Map existing anti-fraud controls to potential fraud schemes
• Test operating effectiveness of antifraud controls
• Identify any control gaps and/or deficiencies = Residual risks
• Document and report on the fraud risk assessment
5. Assess Fraud Risks

• Mitigate Fraud Risks
– Make changes to activities and/or processes = transfer or eliminate the risks
– Improve anti-fraud controls
• Monitor Fraud Risks
– Develop data analytics for management to use to monitor fraud risks
– Utilize Internal Audit to conduct audits of risk areas.
5. Assess Fraud Risks

• All concerns/suspicions of wrongdoing should be reviewed
and determination made whether a fraud investigation is
warranted.
• Develop a policy for fraud reviews and investigations that
specifies:
– Who is responsible for the review/investigation
– Roles of Legal Counsel, Human Resources, Internal Audit, others
– Process for conducting the review/investigation
– Documentation requirements
– Reporting requirements
– When to involve law enforcement
6. Fraud Review/Investigation

• Gather sufficient information and perform procedures
necessary to determine:
– Whether fraud has occurred
– Loss or exposure associated with the fraud
– Who was involved and how it happened
• Must prepare, document and preserve evidence sufficient for
potential legal proceedings.
• Include experts = Certified Fraud Examiner (CFE)
6. Fraud Review/Investigation

• Use lessons learned from any fraud reviews or investigations
to improve anti-fraud controls.
• All fraud review and investigations should include a report to
management with recommendations for control
improvement.
7. Improved Controls

1. Separation of duties
2. Documentation
3. Authorization and
approval
4. Security of assets
5. Reconciliation and review
Top 10 Governmental Internal Controls
6. Policies and procedures
7. Fraud Policy and reporting
8. Access to systems
9. Physical control
10. Verification (i.e. pre-
employment)
To ensure proper stewardship of public funds:

Fraud Self Assessment
Fraud Prevention Self Assessment.docx

Ron Steinkamp, CPA, CIA, CFE, CRMA, CGMA
Partner, Advisory Services
Brown Smith Wallace LLC
314.983.1238 (Direct)
rsteinkamp@bswllc.com
Contact Information

Fraud Prevention & Detection for Local Government

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