Keeping Honest People Honest
The most important asset to a municipality, or any other type of entity, is its employees. Protection of employees using fraud detection and prevention techniques should be a topic that has great weight in a municipality’s day-to-day operations. The point is to keep honest employees honest, by deterring the opportunity to commit fraud by careful management of fraud risks. Analysis of potential risks among employees is probably the most difficult analysis of all, which will put management skill to the test. First, analyze employees using the fraud triangle. The fraud triangle’s sides are non-sharable financial problem (for example, gambling, drug abuse, debt), rationalization (for example, low wages, poor ethical environment), and opportunity (for example, lack of segregation of duties). When an employee meets all three sides of the fraud triangle, he or she becomes a risk. To mitigate that risk, consider whether job duties can be modified to include more oversight, thereby removing one side of the fraud triangle (opportunity), or reassignment of the employee to another position. Modification can be the most cost effective method, where deterrence can be the best protection. If the employee becomes aware that his or her work is being scrutinized, a side of the triangle or opportunity has been removed. A suggested modification can be to have a manager reperform daily cash transactions. To manage fraud risk, municipalities should consider management’s attitude towards ethical behavior, identification of fraud risk areas, and creation of effective internal controls.
It is common sense that management sets the organizational tone. Typically, when fraud is discovered in a municipality there is a direct correlation with the poor ethical tone set by management. It a perfect world, employees should see management as being ethical in mind and fact. However, if employees see management as being the opposite, then they feel that unethical behavior is acceptable and even tolerated. Fraudulent misrepresentation is the most common form of fraud by management, whereby management attempts to elicit reliance by others (that is, employees) on information that contains a misrepresentation. Common examples are recording revenues against expenditure accounts in order to fraudulently increase the budget amount available, or to artificially increase or decrease fund balance so that management can reduce the tax levy, or hide an available revenue source from its taxpayers. All of these examples result in boards and taxpayers making decisions based on inaccurate information.
One way to help set management tone on ethical behavior is for the board to establish and distribute a resolution stating that it expects employees to work to high ethical standards.
Identification of Fraud Risk Areas
Identification of risk areas is at first a difficult task, however, with practice, becomes clearer and more manageable. The municipality should consider risk areas in revenue collection, invoice and payroll payment, misappropriation of assets and services and an analysis of employees.
Generally, municipalities do a good job in identifying risks in relation to revenue collection. However, when considering revenue collection, the municipality should have policies that prescribe how the employee collects and reports revenues. This policy should address segregation of duties, audit trails, controls over currency, daily cash out and its deposit, and the simultaneous reporting of receipt information to both the treasurer and the accountant.
Risk of misappropriating assets through the invoice and payroll process seems to be overlooked by many municipalities. Common examples have been fraudulent invoices and payroll support. In respect to invoices, some fraudsters have created invoices that look like any other invoice that has been paid through the normal disbursement process without notice. To detect and prevent this type of fraud, municipalities should review vendor lists for inappropriate vendors, require employee identification numbers from all vendors, have proper levels of approvals and scrutiny that may include approvals at the requisition and purchase order level, and adequate segregation of duties.
Misappropriation of Assets
Because assets of municipalities typically cannot easily be misappropriated, the risk is that the assets may be converted into another form prior to theft. Theft of scrap metals appears to be a good example, where an employee who is charged to bring scrap metals to a recycler receives the revenues rather than the municipality. Similarly, an employee in full contact of the billing and collection of a receivable (for example, water) could pocket receipts without detection. A proper segregation of duties would prevent such occurrences.
Creation of Effective Internal Controls
Effective internal controls are critical for any organization. Segregation of duties is probably the most important part of internal controls. Segregation of duties is where no one person has control over an entire function. A situation whereby an employee receives revenues, creates reports to the Treasurer and Accountant, and takes the receipts to the bank is an example of poor segregation of duties. Rectifying this problem requires additional oversight of the process and separation of the duties. Other controls that can be employed are the use of prenumbered licenses and forms that can be reconciled back to bank deposits, clear audit trails, and reconciliation forms that require review and a sign off from a manager.
In summary, the key to keeping honest employees honest is managing fraud risk areas within the municipality. Implementing policies for management’s approach to ethical behavior, identifying fraud risk areas, and creation of effective internal controls may initially come with additional effort; however, the rewards of protecting employees and the municipality from fraud are worth the effort.
Matthew Angel is a CPA with the firm of Melanson Heath & Company which specializes in commercial, not-for-profit and municipal auditing, accounting, tax and advisory services, as well as fraud and embezzlement detection and investigation.