Back when the scandal became public, I checked Bell’s website for financial reports, but could not find any. That alone made me suspicious even before the steady stream of allegations about Rizzo and company started to flow.
Perhaps the audit firm did not see the handwriting on the wall, but I would have to know what the scope of the audit was, the reports issued and their contents before really weighing in on culpability.
I do have a problem, though, with connecting a financial audit report with the term “clean bill of health.”
Allow me to get hypothetical – absurdly so – to make a point.
It is possible that Al Capone could have produced complete and accurate financial statements for his criminal operation; maybe even filed his tax returns. They may have indicated that his organization was financially sound. However, I doubt anyone would have described them as a “clean bill of health.” Also pity the poor accountant whose job it would have been to prepare Al’s reports and returns. He would have had to swap his wingtips for a pair of cement shoes.
You have to distinguish between financial audits and forensic audits.
The primary purpose of a financial audit is to determine if the financial statements and disclosures by an entity are reasonable representations of its actual condition. An entity does not have to be “healthy” to receive an unqualified opinion; nor does a favorable audit mean there is an absence of fraud.
Part of any audit is an evaluation of the internal controls – the checks and balances designed to prevent material errors or misrepresentations. Good internal controls also make fraud more difficult to commit, although nothing completely eliminates its possibility. Collusion involving key people could defeat sound controls, at least for a time.
The Times article quotes from a report issued by State Controller John Chiang, “ We found the city of Bell’s administrative and internal accounting control system to be, in effect, nonexistent, as all financial activities and transactions revolved around one individual — the former chief administrative officer — who apparently had complete control.”
If this is true, Bell violated one of the most sacred of internal control rules: separation of duties. You always read stories about the bookkeeper who tracked the cash receipts, deposited the checks, paid the bills and prepared all of the accounting entries. The end is always the same – the bookkeeper takes the company for all it is worth.
When auditors encounter weak internal controls, they are supposed to modify their procedures, including (but not limited to), expanding transaction samples, performing more analysis, asking more questions of the client’s staff, etc.
If the increased scrutiny turns up evidence of anomalies or fraud, a forensic audit is probably advisable, assuming the client is cooperative. Because of its objective, a forensic audit is more detailed and focused on activities rather than financial statement presentation and disclosures.
The Times suggests that sloppy auditing might be prevalent throughout the state.
I do not suspect the City of Los Angeles has a problem with its external auditors, but one should not assume their objective is to discover fraud. If anything, their audit reports (see pages 1 and 2) clearly state the purpose, as they should, as “obtaining reasonable assurance about whether the financial statements are free of material misstatement.”
That leaves a lot of wiggle room in a multi-billion dollar organization. Los Angeles is large enough to have several Bell-style operations occurring within its departments. A scheme in the DWP was only recently uncovered despite operating for years.
It is worth noting that the auditor’s report to the City in 2010 stated there was a deficiency in internal control over financial reporting . The deficiency was considered significant, but not material (
http://phinvv.files.wordpress.com/2010/11/simpson-and-simpson-internal-control-report.pdf
).
The nature of the deficiency is not described in the report, but was said to be included in a schedule of findings. I could not locate that document.
Even if the deficiency was not material at the time of the report’s issuance, the fact that it is significant could make it material at a later date.
It is interesting that Controller Greuel did not distribute an e-mail blast as she routinely and immediately does when problems are uncovered in other areas of the city.
The external auditor’s finding concerned her department.
Paul Hatfield
Suzanne Lauer
The auditors can always question whether the entity is an on going concern.
One of the underlying assumptions of GAAP is that the entity will be in operation indefinitely.
Therefore, an organization deemed to be in a death spiral would be out of compliance. By contrast, one undergoing a temporary financial crunch with reasonable prospects of recovery would be in compliance, all other things being satisfactory.
That begs the question: what is the future of Los Angeles?
If bankruptcy were likely, I would expect the external auditor to issue a qualified opinion, perhaps even before the process commenced.
Given the gloomy long-term forecast for the pension system, escalating health care costs, this is worth a discussion.
The city has a very limited ability to raise taxes. It is essentially at the mercy of the state and federal governments. Unless it can renegotiate its contracts, I would not call LA a going concern.
Good post Paul. Its unfortunate that the LA City Controller can’t audit every City Council office at this point. I, like many others believe that’s where LA would have similar dealings as the City of Bell with misuse of funds. I don’t understand why Wendy is doing all these audits when she doesn’t come up with a solution how to avoid it in the future from happening if there’s no checks and balances in place. Case in point is the $541 Million outstanding debt to the City yet, no one is taking steps to try and collect it. Everyone is passing the buck and stating there’s no financial system in place to go after the debtors. That to me sounds insane!!1
I hope that we’re not overlooking the obvious here; that the number one goal of an independent auditor is to keep the gig. If an independent auditor were to uncover anything that looked like misrepresentation, or even mild fraud, they would need to report it to the people who are paying them. The solution is simple; hire another auditor, and this time, tell them to “do it right, this time [wink, wink]“.
In Ms. Greuel’s case, there are higher offices within the City to consider and you don’t want to make any enemies so soon.
Isn’t anyone curious as to the audit regarding the $111M in Federal ARRA stimulus funds that were earmarked to go to the Department’s of Transportation and Public Works? We know where a small portion of that money went to, but the whereabouts of a majority of that money is still a mystery. Why is that? And what about the $423M ARRA funds remaining from the $534M received in March of 2010? Who or what Department has custody of that money and is it collecting any interest?
Who’s auditing the auditor?
Auditors do want to keep their gigs; unfortunately, some have sold principles to stay on the job.
A responsible CPA firm will not risk its reputation, not to mention its existance, by playing it fast and loose. I have more concern about competence in some cases as opposed to fraud.
Poor judgment by auditors could lead to disaster as much as fraud.
That’s why I raised a question some weeks back about the selection of the firm hired to conduct the workers comp audit. I did not see any workers comp experience in their background.
Furthermore, it was not even a CPA firm (although the owner is a CPA).
The firm appeared to be a favorite of local governments. It makes me less than confident in their work.
Paul, are there grounds to be suspicious about the City Controller’s audits also? And, if you know, what independent or contractor auditor/CPA has had the longest contract with the City?
I don’t know who has the lingest contract, but it seems Simpson and Simpson has been doing the financial audits for a number of years.
Rose and Associates from San Francisco seems to be a popular firm used for specialty audits. However, Rose and Associates is not a CPA firm. They did the workers comp “audit” although I could not find where they had any prior experience with subject matter. To me that’s a red flag that someone is playing favorites.
The City Controller audits themselves are technically OK from what I can tell, but follow-up is non existant. Audits without assuring the recommendations are acted upon are nothing more than paper reports. Also, I have to wonder about how audits are prioritized – not enough emphasis on potentially significant problems.
[...] 16, 2010 by Paul Hatfield I commented on the controversy concerning the City of Bell audits earlier this [...]