Fraud squad: exercise comprehensive financial controls to safeguard association assets.

IN CALABASAS, CALIFORNIA, THE property manager of a 268-unit homeowners association stole $1.5 million during a seven-year period before his activities were discovered. He used a common ploy: He ordered from the association's bank a second set of consecutively numbered blank checks identical to the checks used by the association. He then periodically made out some of the duplicate checks with himself as payee--while presenting for signature to the association president and treasurer legitimate checks, which were made out to bogus vendors or to legitimate vendors whose invoices had already been paid. When he received the association's monthly hank statements, he was able to substitute the seemingly real checks for the checks made out to and cashed by him, thus covering his tracks. Using photocopies with false payee and bank endorsements, rubber stamps ordered at a local stationery store, two blind bank accounts unknown to the board, and a set of false financial statements--including phony letterhead of a nonexistent certified public accountant--the property manager was able to elude detection even while the hoard requested copies of cancelled checks and a full-blown audit. He' was caught because homeowners began to complain that they saw no evidence of the improvements for which they were charged ever increasing assessments. The perpetrator eventually received a jail sentence of six years for check forgery and grand theft.

This is but one of a spare of recent incidents reported by Ova press, indicating what seems to be an alarming increase in losses suffered by associations from fraud and embezzlement. (See sidebar, "Fraud Knows No Bounds," for specific incidents.) No single type of nonprofit organization holds a monopoly on the problem. Homeowners associations, charitable organizations, trade associations, community groups, and religious organizations haw' all suffered losses. Recent high-profile corporate and nonprofit scandals have heightened awareness of a board's fiduciary responsibilities, and many associations have reviewed and revised their procedures. Nevertheless, opportunities to commit fraud and do not magically disappear and are an ever present danger.

Pervasiveness of fraud

While the number of reports of association fraud is high and includes several high-profile cases, no statistics about the amount of fraud and its effect solely on associations are available. Part of the problem is the difficulty of detecting fraud in tire first place. Fraud that is detected is not always reported, because it is so damaging--resulting in financial loss, damage to an association's reputation, negative publicity, internal upheaval, and in many cases, loss of donors and members.

Estimates of fraud in business in general differ significantly among surveys. However, in a 2002 research study ("2002 Report to the Nation on Occupational Fraud and Abuse"), the Association of Certified Fraud Examiners, Austin, Texas, estimated that fraud costs American businesses approximately 6 percent of revenues, or $600 billion annually. While it is commonly believed that fraud only occurs ill large, multinational organizations, the ACFE study found that the most costly abuses occurred in organizations with fewer than I00 employees.

As the press reports more and more fraudulent activity involving misappropriation of assets and issuance of misleading financial reports, fraud and business ethics have become hot topics on college campuses--with college professors holding a dramatic increase to requests from businesses, trade groups, and nonprofits for information on fraud prevention, detection, and prosecution. The recent movie Catch Me If You Can, describing the exciting life of former professional fraudster Frank Abagnale, has increased public awareness about fraud, including identity theft and embezzlement. College business courses now include cases and discussion about business ethics, resolving moral dilemmas, and establishing internal control procedures to prevent and deter theft.

Associations are particularly vulnerable

In the booklet Preventing Fraud: How to Safeguard tour Organization (2001, BoardSource), authors Andrew S. Lang and Tammy Ricciardella suggest that nonprofit organizations are particularly vulnerable to embezzlement for a number of reasons, including a high atmosphere of trust. Because staff and volunteers are often charged with the mission of helping those in need, they are rarely suspected of acting in a deceptive manner. This atmosphere results in a higher level of trust than that associated with most for profit businesses. In addition, association management, staff, and board members are sometimes unfamiliar with the importance of strong accounting and financial controls. Board members are sometimes reluctant to get involved in association financial operations or don't realize that accountability and control of funds is critical to shoat-term success and long-term survival. As recent events have shown, however, everyone involved (not only the treasurer) has a fiduciary responsibility to understand the financial aspects of running an association and making sure that fraud does nor take place.

Other factors that heighten the risk Of fraud in nonprofit organizations include

* contributions that are made from numerous locations and sources;

* donors who make cash donations and do not ask for receipts:

* volunteers who are not properly trained or supervised;

* failure to conduct background checks on these volunteers; and

* in an effort to hold down managerial costs, the hiring of staff members with limit knowledge of accounting, which leads to inadequate policies and procedures to prevent, detect, and correct unintentional errors as well as embezzlement.

Understanding the elements of fraud

Common elements set the stage for Fraud. In general, the organizations lacked effective internal accounting control procedures--including separation of duties and responsibilities--had bad record keeping and a lack of proper documentation to substantiate counterfeit transactions, and had failed to establish independent checks on performance. In retrospect, it was fairly simple for each fraud perpetrator who was put in a position of trust, to commit multiple thefts that went unnoticed for a period of time.

In general, fraud involves serious wrongdoing with malicious intent for the financial benefit of an individual. fraud includes three essential elements: 1) misrepresentation or concealment of significant information by the perpetrator; 2) the victim's reliant e On the perpetrator's misrepresentations; and 3) the victim's loss Of something valuable. Throw in a bit of greed, lack of ethics, and an oversized ego, and you have the ingredients for a fraud that can adversely affect an association and its members.

Consider the case of the California homeowners association. The board of directors relied on the property manager to collect all assessments, deposit them into the association's bank accounts, pay all the association's bills, reconcile all bank statements, prepare monthly reports, and hire a CPA to do the annual audit. Too much responsibility was given to one individual, who then took advantage of the situation. Internal accounting controls were lacking, and falsified documentation was used to support unauthorized payments to the property manager. The board members admitted in court that they did not know what the property manager was doing and relied--for an extended time period--on financial reports that were misleading. The $1.5 million loss was discovered only after homeowners complained that repeated special assessments had led to no major improvements in the buildings and landscape.

Recognizing signs of fraud

At the onset, fraud is rarely obvious to others in the organization. However, red flags and telltale signs generally emerge. Observation of a person's habits, especially changes in habits and lifestyle, are indicators that something may be seriously wrong, especially when a person spends more money than seems reasonable to refurbish a home or buys expensive jewelry, clothing, a boat, a new car, or a vacation home. Fraud perpetrators frequently like to gamble and brag about their winnings. People who commit fraud generally have difficulty looking other people straight in the eye, become easily irritated, are defensive and overly argumentative, and find excuses and scapegoats when someone finds errors and irregularities that he or she is trying to conceal.

Indicators of fraud also appear in the accounting records, including missing bank statements and reconciliations, general ledgers that do not balance, missing and altered documents, photocopies rather than originals, unexplained cash shortages, unauthorized credits to receivable accounts, increased past due accounts, duplicate payments to vendors, unauthorized purchase transactions, and payments for unspecified services.

Deterring or preventing fraud

It is the responsibility of the association executive as well as the board to safeguard the organization's assets. We recommend the following actions be taken on an ongoing basis to fulfill that duty.

1. Keep association records up to date. These include cash receipts and disbursement journals, the general ledger, subsidiary ledgers for member receivables, donor and other revenue reports, and payroll records. In some cases, it may be advisable and possible to provide all board members with access to these records and reports. In other situations, particularly if the governing board is large, it is more effective to limit access to such information to the finance or audit committee.

2. Assign the board control of all reserve funds. Keep detailed records on all reserve transactions, with board minutes reflecting approval of all transfers of reserve funds.

3. Prepare monthly financial reports and make them available for board review. Include in the monthly reports a balance sheet, a statement of revenues and expenses, and a comparison of actual revenues and expenditures to budgeted amounts. The board then reviews these reports, along with written explanations of any significant fluctuations in cash, receivables, payables, revenue, and expense categories.

4. Update hank signature cards when an authorized signer leaves the association or resigns. Require two signatures on all checks or transfers greater than a predesignated amount.

5. Prior to signing checks, authorized check signers need to review invoices and supporting documentation. Verify, vendor invoices for accuracy in quantities ordered and received, prices charged, and overall clerical accuracy. Stamp invoices and supporting documentation as "paid" to avoid duplicate payment. And never allow checks to be made out to "cash" or sign blank checks in advance. Deface voided checks and keep them on file.

6. If advances to key employees are made, restrict amounts to predetermined limits. Similarly, verify, that expense reimbursement requests are for legitimate association expenses and are substantiated with original receipts. Maintain reasonably low limits for all credit cards issued to employees in the name of the association.

7. Review bank statements and reconciliations on a monthly basis. Give the assignment to someone not involved in handling cash receipts and disbursements. Instruct the person reviewing the documents to question and investigate all reconciling items that do not clear in the following month. As part of the monthly reconciliation process, review paid checks that accompany the bank statements for authorized signatures and proper endorsements.

8. Keep only a small amount of petty cash on hand and in a secure place. Assign to someone other than the person who controls the fund the responsibility of reconciling the cash and receipts periodically and without notice.

9. Regularly review delinquent receivable balances. Properly document and approve any write-offs.

10. Obtain multiple bids for all major contracts, and check references provided by suppliers. One method used to obtain comparable bids for goods and services is to provide each vendor a request for proposal (RFP). With specifications in writing, vendors know exactly what they are bidding on, and it is easier to compare bids based on the same set of specifications. Bids based on a well-constructed RFP eliminate the problem of vendors who hid low and later increase the agreed-upon price with extra charges. Consider only reputable vendors who are licensed and insured. Avoid soliciting and accepting bids from related parties and those with conflicts of interest.

11. If your association has paid employees, take actions to ensure that fictitious employees are not paid. Regularly review payroll registers aim paychecks before they are distributed to employees and verify employees' individual pay rates on a regular basis. Make sure that no employees are added to the payroll without the proper authorizations from the human resources department.

12. Purchase adequate fidelity insurance to cover volunteers and employees who handle funds. In addition, arrange for directors and officers coverage in the event the board is accused of financial mismanagement.

13. Adopt a written policy regarding kickbacks, discounts, credits, and conflicts of interest. Write employment agreements and management contracts such that they clearly start that kick-backs from contractors and other vendors will not be tolerated. Any benefits or free services provided should be to the benefit of the association, not the manager, individual board members, or employees of the association. Employ a process that discloses any possible conflicts of interest.

14. Hire a CPA who is familiar with accounting and auditing standards published by the American Institute of Certified Public Accountants to conduct an independent annual review or audit. AICPA has issued special standards for nonprofit organizations. By reviewing the standards, you'll also understand the distinction between a review and an audit. A review requires the CPA to perform analytical procedures and make certain inquiries to provide "limited assurance" that the association's financial statements are in accordance with generally accepted accounting principles. Audits are more comprehensive and provide a high level of assurance, but are more costly.

When selecting a CPA or CPA firm, arrange for key members of the board, specifically those on the finance or audit committees, to interview the parties. Conduct a through review or audit whenever a major change in handling the association's financial records occurs; one such circumstance would be a change in key management personnel.

Taking action when fraud is discovered

If you discover that funds are missing from your association, it is critical to take the following steps without delay.

* Remove the suspected fraud perpetrator from a position of control. Secure all books and records.

* Put a stop on all bank account activity, Require the bank to call a trusted person--someone on the board or finance committee who has no immediate access to funds--before any checks or withdrawals against existing accounts are processed. Consider closing current accounts and opening new accounts to stop any fraudulent activity in progress.

* Review bank signature cards. If necessary, change authorized signers.

* Gather and secure all documents and evidence related to the crime. In the homeowners association example, this might have included evidence of duplicate checks, falsified financial reports, and other altered documents.

* After checking with your association lawyer for advice on how to handle the discussion, interview the perpetrator, if possible. Fraud, like death or serious injury, is a crisis situation. People in crisis have a predictable sequence of reactions, which may unfold something like this: denial, anger, rationalization, bargaining, depression, and, in some cases, admission.

Even if you are convinced that the perpetrator is guilty--and have solid evidence to support your conviction--he or she will likely he reluctant to admit guilt. Take special pains to be polite and careful with the language that you use during the interview. For example, don't condescend or talk down to the person; be friendly, but conduct the interview in a businesslike manner; listen carefully to responses; use short questions that require a narrative response; don't let the perpetrator lead you away from the question, confuse the issue, or leave basic questions unanswered; and, above all, maintain control of the discussion.

At the conclusion of the interview, escort the person from your premises. If the perpetrator is a staff member, explain that he or she is on leave until the investigation is concluded. If the person is the financial committee chair or someone in a position to have tampered with reserve accounts, explain that responsibility for the organization's funds has been assigned to someone else.

* Consider reporting the problem to the police or local authorities. You will need to provide information concerning the date, time, and place of the occurrence of the fraudulent activity; the manner in which the alleged crime appears to have been committed; possible motives; and, above all, evidence.

Although stolen funds must be returned to the organization as restitution after a criminal investigation, the likelihood of recovering any money from the suspected perpetrator is small, even if he or she is convicted. However, reporting the crime serves other purposes, including deterring other employees from committing future fraudulent acts.

* If you have fidelity insurance coverage, consider calling the insurance company and filing a claim.

* Call your association's attorney to obtain advice about how best to proceed. Discuss whether it is advisable to bring a lawsuit against the responsible party, if and how to file a criminal complaint, and other issues of which you are unsure. Before considering bringing a civil suit against the suspect, consider the following: Is sufficient evidence obtainable? Are funds available to pay restitution?

Final recommendations

Clearly, the possibility of fraud exists in every association. By taking deliberate, preventive measures, you can greatly reduce the likelihood of financial mismanagement and fraud striking your organization.

First, develop a risk management program to reduce the possibility of asset misappropriation and the resulting negative publicity. Risk management is an operational strategy to strengthen an association's operations by anticipating losses and taking measures to prevent them from occurring.

Second, implement a good system of internal accounting controls to create an organization hostile to fraud, improve the trustworthiness of all individuals involved, and detect theft and losses before they undermine your operation and mission.

Finally, define in writing acceptable and unacceptable activities in your organization. Fully investigate suspected fraud, and treat offenders in a consistent manner. A focus on fraud prevention may very well be the key to your association's long-term viability.

FRAUD KNOWS NO BOUNDS

The examples of financial fraud and mismanagement that follow underscore the scope of the problem:

* As reported in a January 22, 2003, article in the Lansing State Journal, $1.9 million was stolen from the United Way, East Lansing, Michigan, by a former employee who served as its finance officer. Initially, charity officials were hopeful that the incident was confined to 2001 and 2002--the last two years of the finance officer's 20-year tenure with United Way. But after reviewing bank records, it appeared that the finance officer was cashing stolen checks made payable to her for at least six years.

* In San Ramon, California, a youth football team was the victim of an embezzlement scheme in 2001 by a parent who served as president of the local organization. The estimated loss was reported to be $14,000-$40,000, but could not precisely be determined because the association kept no record of gate receipts or snack bar sales. Cash collections apparently never made it to the bank. The president denied any wrongdoing, blaming unidentified "con artists" for the missing money. The embezzlement was discovered when an investigation of insufficient-fund checks revealed that the president wrote several checks to a family member, an auto repair shop, the telephone company, and a number of other people. The team had no vehicles or telephone.

* In 2000, the former president of a West Virginia parent-teacher association was arrested and accused of stealing $25,000 from the organization since 1999. She was accused of using the money to purchase money orders to pay her personal bills and depositing cash proceeds from various fundraisers into her own bank account.

* As reported in the November 11, 1996, edition of Christianity Today, the former treasurer of a Connecticut Council of Lutheran Churches was arrested and accused of embezzling $800,000 from endowment and restricted-fund accounts. Auditors discovered funds missing in an investigation that started about the time the treasurer resigned. The alleged perpetrator had been the regional treasurer for the 77,000-member association for 12 years. He was charged with several felony counts, including larceny, money laundering, and state income tax evasion. Allegations included the treasurer's use of church funds to pay for resort vacations, vacation homes in Cape Cod and Vermont, and tuition for his two sons who were attending Yale University and Boston College.

* In January 2003, an emergency-crew volunteer in Big Island, Virginia, was indicted on embezzlement and money laundering in a $31,000 theft of rescue-squad funds. The volunteer was the crew's cardiac technician and treasurer for 20 years. The stolen money was laundered through her job at a local post office, presumably through the purchase of money orders.

QUICK TIPS TO DETER FRAUD

To minimize the chances of your association being the next victim of fraud, periodically review this checklist and take action when you see any irregularities.

[] Put internal accounting control procedures in writing and update them as circumstances dictate.

[] Ensure proper design and use of documents.

[] Establish levels of authorization and make sure that they are followed without exception.

[] Restrict access to blank forms, accounting records, and assets.

[] Segregate duties so that one person does not handle nil aspects of a particular transaction.

[] Establish independent checks on performance.

[] Implement external oversight with an annual audit by an independent accountant.

The authors are all certified public accountants and are affiliated with California State University, Northridge. Ronald S. Stone holds a doctorate in management and is a professor in the department of accounting and information systems. E-mail:[e-mail]. Catherine T. Jeppson holds a master's degree in business administration and is a full-time lecturer in the department of accounting and information systems. E-mail:[e-mail]. Edward H. Julius holds a master's degree in business administration, and is a part-time lecturer at CSU Northridge, and is department chair and professor of accounting at California Lutheran University, Thousand Oaks. E-mail: julius @clunet.edu.