Mike Boehm of the Los Angeles Times reports today that an employee of the Orange County Performing Arts Center was sentenced to 10 years in prison for embezzling $1.85 million. See, M. Boehm, O.C. Arts Center Embezzler Sentenced, LA Times, Mar. 28, 2006. The scheme was perpetrated over a five-year period, with the bulk of the proceeds being used to finance the employee's gambling activities.
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Financial Controls are Vital. Did the scheme require a PhD in accounting or finance to pull off? Apparently not. The article does not describe the scheme in detail, except to note that the scheme involved the doctoring of records. It was discovered when auditors compared cash register receipts against bank statements. Later in the article, Mr. Boehm reports that OCPAC would now separate the bank reconciliation function from the bank deposit function. To accomplish this, OCPAC hired an additional employee. Separating incompatible functions is the most basic weapon in the arsenal against fraud. It is always easy to do after-the-fact, but far more effective if done before the theft.
Where There is One, There are Sometimes More. Mr. Boehm reports that there was a $42,000 embezzlement by another employee in 2000. Once an organization determines that it has weak controls, it should undertake a thorough review of its systems to make sure that others are not taking advantage of the weaknesses.
The Trusted Employee. We don’t know whether the employee’s peers viewed her as the “most honest person on earth.” However, she had been employed by OCPAC since 1995. Thefts by long-term employees are not unusual. In fact, some statistics suggest that the longer the thief's tenure, the bigger the loss.
Gambling is a Problem. This is not the first case where an employee has embezzled funds to cover gambling losses. Gambling is not without it costs. Employers must take precautions to make sure those costs are not borne by them.
Management, Not the External Auditor, is Primarily Responsible for Detecting Fraud. Mr. Boehm reports that OCPAC replaced the external auditor that certifies OCPAC’s financial statements. Although OCPAC probably had to do this as a public relations matter, this action reflects a fallacious belief that the role of the independent auditor is to detect fraud. Management is responsible for preventing fraud by putting in place adequate control systems. Moreover, management is responsible for performing internal audit procedures designed to detect fraud.
The independent auditor is engaged to audit to the financial statements to make sure they fairly present the financial position and activities of the organization. In this case, the average annual fraud was slightly less than $400,000. Although this is a lot of money in the big scheme of things, this is not necessarily a material amount in terms of an organization with a $40 million annual budget. SAS No. 99 clearly tells auditors to keep an eye out for fraud during the audit and offers many suggestions on how to do that, but it still makes fraud detection the primary responsibility of management. Boards and nonprofit managers make a big mistake when they look to external auditors to uncover fraud.
Fidelity Insurance Pays, But Not Totally. Mr. Boehm reports that insurance covered $1.0 million of the loss (less a $10,000 deductible). Better financial controls might have prevented the loss altogether. Moreover, OCPAC probably faces higher insurance premiums and some donors may decide not to contribute after reading the article. Additionally, if legal and investigative costs were outside the policy limits, the net loss to OCPAC may have been larger than the uninsured portion of the actual theft.
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