Cash Concerns

Carl M. Cesarano is a partner in Cesarano & Kahn, CPAs.

During the 1990s, investigations by the Manhattan district attorney’s office resulted in numerous criminal indictments of commercial contractors, engineers, managing agents, and others providing services to co-ops and condos. In May 2006, a former accountant for one of the largest co-op developments in Queens was charged with embezzling more than $90,000 between July 2002 and August 2005.

The fall of an organization because of accounting irregularities and fraud is a story that appears too frequently in today’s newspapers. No organization is immune and, regardless of its size, the effects can be devastating. Despite the growing occurrence of accounting irregularities and fraud, co-ops and condos often do not take the basic measures needed to prevent and detect fraud, which, in turn, leaves the organization exposed to potentially devastating economic losses.

Co-op and condo boards need to proactively institute guidelines, procedures, and controls to prevent and detect fraud. The board must establish and maintain guidelines for selecting managing agents, contractors, vendors, and other professionals. The board should also ensure that the manager keeps books and records that, in reasonable detail, accurately and fairly reflect the organization’s transactions.

The spate of fraud scandals led to passage of the Sarbanes-Oxley Act (SOX) in 2002. Section 404 of SOX requires corporations to evaluate and report on the effectiveness of their system of internal controls over financial information. Although SOX is currently only applicable to publicly traded companies, similar standards will probably be required of private ones in the future.

Control Issues

Boards need to establish and implement financial controls that are applicable to the building’s finances, whether handled in-house or by an outside management company. All management firms should be held to the same high standards as if the work were done internally. Therefore, boards should review monthly management reports, including cash balances, bank reconciliations, and revenue-collection reports.

Boards should also establish and monitor an operating and capital budget (i.e., make sure you have an idea of a building’s revenues and expenses). This can help identify unusual fluctuations or relationships among balances when compared to actual results.

Proper segregation of duties is an effective guard against fraud. For example, individuals responsible for the collection and recording of cash and checks should not also maintain lists of open invoices. Lockboxes are an effective method of preventing fraud as checks are sent and processed by the co-op or condo’s bank, not the managing company. The bank then provides a list of cash and check receipts to management for its use in bookkeeping. The goal of segregating those who handle money from those who record the receipts is achieved.

Segregation of duties over cash disbursements should also be addressed. Only authorized individuals should have access to blank checks, and payments should be made to pre-approved vendors. Checks for large amounts should only require board approval and dual signatures, and non-recurring payments or payments to additional vendors should be approved on a case-by-case basis. In the example mentioned earlier, a manager was able to perpetrate an $80,000 payroll fraud because he was allowed to approve payroll expenses and also write and approve paychecks.

Oversight over management companies is especially necessary when addressing major renovations and the selection of contractors. Be sure to get references before hiring. The board should retain an independent engineer or architect for any construction project to prepare specifications and bids. As part of the bidding process, send construction projects out for bid and require at least three bidders on small projects and five bidders for significant ones. Bids should be opened at a board meeting or in the presence of several members of the board – and low bids should be closely scrutinized (the lowest is not always the best).

Consider hiring a construction manager or owners’ representative to control and monitor large projects (this should include weekly on-site meetings with representatives of the board, managing agent, superintendent, engineer, and contractor). The board may also want to consider a second engineer to provide peer review when conflicting or unclear positions exist as to the scope of the work.

The board must continuously evaluate its system of guidelines, procedures, and controls to maintain compliance with the requirements of its established policies. The board must also take action to minimize the risk of accounting irregularities and fraud. The process of establishing and monitoring controls and procedures is constantly evolving as both the environment and the type of fraud risks change.

Another way for the board to protect against becoming a victim of fraud is the prudent selection of the type of annual financial report to issue. The preparation and distribution of such statements is typically required in the bylaws of an organization. Bylaws, located in the offering plans of co-ops and condos, constitute the code of rules for the regulation of their affairs and usually state that the financial statements should be prepared by an independent certified public accountant (CPA).

The statements are typically required to include a balance sheet at the end of the prior fiscal year and a profit-and- loss statement for the entire prior fiscal year. Most bylaws do not specify the type of report and the level of service to be provided. This ambiguity allows the board to make its own interpretation.

Consequently, the board may engage the CPA to provide services which offer limited assurance or no assurance whatsoever over the information contained in the statements, leaving the organization with greater exposure to accounting irregularities and fraud.

The Right Type

There are three different types of reports to choose from when preparing the financial statements: audits, reviews, and compilations.

Audits provide the highest level of assurance over the fairness and reliability of the information contained in the financial statements. The differences between an audit and its alternatives are the procedures performed. Audit procedures typically include tests of documentary evidence supporting the transactions recorded in the accounts of the organization.

These procedures may include tests of the physical existence of inventories, direct confirmation of receivables, and certain other assets and liabilities by correspondence with selected creditors, legal counsel, banks, and individuals. The CPA may also employ specialized-testing procedures when direct communication with individuals or businesses is not appropriate.

Auditors also review and evaluate the effectiveness of the organization’s internal controls and accounting procedures. A strong internal control environment produces more reliable financial information and reduces the inherent risk of accounting irregularities and fraud.

Finally, auditors review and verify the entire financial statement to ensure that all required disclosures and any other information needed to fairly present the entity’s position are included. After conducting all necessary audit procedures, the CPA can issue an opinion attesting to the fairness of the financial statements.

Financial-statement reviews offer less assurance than audits. During a financial-statement review, a CPA will inquire of management regarding the accounting methods and practices in use, procedures for recording transactions, and procedures for accumulating financial-statement information. In lieu of testing the balances in financial-statement accounts, the CPA will compare the current year’s balances with prior years’ balances to identify any relationships or individual items that appear to be unusual. The CPA then uses the information to determine whether the statements are in compliance with accepted accounting standards.

The CPA, however, does not perform most of the steps required in an audit and only issues a report stating that based on the review, material modifications to the statements are not needed for the statements to meet professional standards. Thus, a review does not provide the same degree of assurance as an audit.

Compilations are used when an organization requires assistance in accumulating its accounting information and arranging it in financial-statement format. In preparing a compilation, the CPA firm is not required to perform any specific testing, the amount inquiry and analysis of the financial information is limited, and the CPA does not express an opinion or any other form of assurance regarding the organization’s financial-statement information.

When fraud is suspected or has occurred, a forensic audit may be conducted to investigate and gather evidence of suspected fraud, accounting irregularities, and misconduct. This includes fraudulent reporting, misappropriation of assets, and violations of laws, regulations, contracts, or organizational policies.

Compared to regular financial-statement audits, forensic audits require increased resources, such as greater investments of time and audit staff involved. As a result, in addition to the costs resulting from accounting irregularities or fraud, an affected organization will also incur the additional expense of a forensic audit, which is very often cost-prohibitive.

Fraud is a constant threat, and the board must work diligently to prevent and detect it. Implementing strong internal controls, operational procedures, and guidelines are important steps in protecting the organization. Financial statements can provide the independent perspective needed to reveal the financial health of a corporation and to remedy any areas of weakness.