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Investors, taxpayers, and employees suffer real consequences when state and local governments prop up financial statements. Prevention starts with the right tone at the top.

Governance

Fraudulent Financial Reporting Can Hurt Your Government's Stakeholders

  • Christopher Knopik
  • 11/21/2017

Everyone knows that internal fraud is a big problem these days. State and local governments have had their share of employee embezzlement, theft, false expenses, and misappropriation of money. But there’s another, lesser-known brand of fraud to be on the lookout for: fraudulent financial reporting.

Fraudulent financial reporting is the intentional misrepresentation of an entity’s financial statements with the aim of giving recipients a mistaken impression about its operating performance and financial viability. This could be something as simple as purposely overstating or understating a balance sheet account. It could be recognizing revenue upfront on a contract or a lease, or purposely delaying a payable to make a debt covenant. There are plenty of ways to perpetrate fraud on financial statements.

In governments, fraudulent financial reporting is usually committed to get funding for projects and preferable bond ratings, financing terms, and interest rates. Or it may be done to sidestep defaulting on a bond covenant and being hit with a massive expense.

Why governments should care about fraudulent financial reporting

Many government administrators tend to shrug off the seriousness of fraud in financial reports. They regard it as a problem among public companies that want to manipulate stock values. Many seem to believe no one really cares about a government’s financial statements and that there is little motivation for government finance officials to commit a fraud that would not personally benefit or enrich themselves.

But government financial reports aren’t just reading material for compliance reviewers. Investors actually rely on government statements to make decisions and go to market to issue bonds. Fraudulent financial reports put third-party investors at a great disadvantage and position them to lose money or tax-exempt status on earned interest. It is not a victimless crime.

In fact, taxpayers, citizens, and civic employees have also been hurt in recent cases of fraudulent financial statements. The town of Ramapo, New York, suffered the downgrading of bonds; the city of Miami had to raise taxes and cut employee pay and benefits because of penalties; debt spiked at $64 million in the city of Harvey, Illinois. In such cases, fines can be assessed and convicted officials can do prison time. The results are serious, and the harm is real.

When your local government’s bonds meet the requirements for registration with the Securities and Exchange Commission (SEC), you are obliged to submit financial information at least once a year. As an annual submission, these documents must paint an accurate portrait of your operations. Some inaccuracies can be fixed in the following annual submission, but if you were to default on a bond between your financial statement date and your next audit, that error or misstatement could implicate your government.

Your board or council members approve those financial statements when the audit is completed and ready for issuance (normally done via resolution in an open meeting), and this means they are responsible for everything in those statements. And if your local government defaults on a bond payment, the SEC’s Office of Municipal Securities will investigate for fraud. Once the SEC is involved, both civil and criminal charges could occur.

“Tone at the top” is your first defense against fraud

There are many tactical things you can and probably already do to prevent fraud of all kinds in your government, such as segregating duties and monitoring controls. But above all, your senior management and board members must create and promote a culture of ethics and accountability — what we call the proper “tone at the top.” This is one of the most important deterrents to any fraud, regardless of type.

The right tone at the top involves establishing a questioning mindset. Always be skeptical and look deeper into:

  • Financial results that are always on target
  • Extraordinary or complex transactions
  • Cash flows that do not meet revenue growth
  • Swings in assets or liabilities
  • Unexpected changes in auditors

It takes education to investigate these things. Your senior management and board members should learn the details of your operations and how your financial statements interrelate and flow. You should also be trained on financial statement red flags and the differences between aggressive-but-acceptable accounting and abusive-and-prohibited accounting.

How we can help

CLA’s state and local government professionals can help you and your board establish a well-balanced control environment with proper preventive and detection controls. We can review your financial statement processes and protocols and train your people on how to prevent and root out fraudulent financial reporting.