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  • 25 Stories About Work – The Difficulty of Verifying Cash

    Posted by Carl from Chicago on February 25th, 2015 (All posts by )

    I was recently on a plane doodling and thought of some funny / interesting stories from 25+ years of working and traveling. So I decided to write them up as short, random chapters of a non-book with the title of this post. Hope you enjoy them and / or find them interesting. Certainly the value will be at least equal to the marginal cost of the book (zero)…

    The Midwest, early 1990s

    For a long time many governmental entities did not have audits from outside firms.  Beginning in the 1980s and 1990s it became common-place for them to have to open up their books and bring in third party professional audit firms to review their accounts.  If they had not been audited before, we called it a “first time through” audit because the amount of work was exponentially maybe one and a half to two times higher – you had to document the controls, figure out who was who at the client, validate the opening balances, etc…  Typically after the first audit it was much easier because the 2nd year audit just followed the work papers of the prior year auditors (unless you were like me and asked a lot of questions, which is a story for another “25 stories about work” article).

    Recently I thought about my experience when I read this article about the state of New Mexico while reading this article from Bloomberg (a fantastic news source) titled “New Mexico’s $100 Million Accounting Error”. From the article:

    New Mexico can’t balance its checkbook.
    Cash in the state’s bank account is at least $100 million short of what’s recorded in the finance department’s ledger, pushing officials to adjust reserves by that amount, to about $650 million. The blame, the current administration says, lies with the introduction of a new accounting system in 2006.

    While it would seem astonishing that in this day and age, when you have on-line bank statements and immediate access to data for personal accounts, that a governmental entity could be that far off the mark, it wasn’t shocking to me. As a new auditor at this first-time through audit, I was given what was thought to be the simplest of tasks – auditing the cash on the books and reconciling this cash balance to the bank statement.

    How you and I and almost everyone else operates is that you have a checkbook balance and as you make a payment (write a check), you deduct that amount from your available cash and you then know how much money you have left in your account. Since deductions can come in many forms (ATM withdrawals, auto-payments, and manual checks) you need to balance your checkbook periodically to make sure you don’t miss anything, but other than that it isn’t that difficult conceptually. The same process obviously works in reverse for deposits.

    The governmental entity I was auditing in the early 1990s, however, used a totally different philosophy. They assumed that they HAD the cash forever until you proved that the check was cashed by whomever they sent the payment out to. Thus when you started to look at the bank balance “on the books”, it showed hundreds of millions of dollars. When you looked at bank statement (from the bank), you saw a few million dollars. Thus my nearly insane task was to reconcile out the hundreds of millions of dollars in payments that had been made over the years to get from all the cash deposited back to the few million dollars left on hand. To be fair, staff at the governmental entity had taken a “crack” at this task and there was lots of manual records attempting to bridge the gap, but it was still a giant effort. New Mexico apparently uses the same “model” today – per that Bloomberg article:

    Officials commissioned a study on the variances between the state ledger and its bank accounts from fiscal 2007 through February 2013.
    Contractors could match only 2 percent of 160 million entries to a corresponding bank transaction, according to a Jan. 19 memo to lawmakers from Legislative Finance Committee staff.
    Hundreds of thousands of transactions totaling more than $836 million are absent from the system, the study found. It estimated that the state could have from $76 million to $400 million less than its records reflect.
    Clifford said he requested $3.4 million to create processes to properly record cash balances. It will take about two years to achieve a “clean” annual financial report, he said. Should the imbalance exceed $100 million, the gap would come out of reserves, he said.

    I still remember writing up memos attempting to explain this situation to the partner on the engagement. We did not have a lot of time set aside for auditing cash, which is supposed to be simple, and when you bid out these governmental jobs we were already doing the work at a loss (compared to standard billing rates) so there was little or no tolerance for spending extra work at this unprofitable client. Thus I was not only handed an impossible task my own firm was not pleased with my careful documentation of this situation which caused them to have to spend even more time writing memos to provide credence to the numbers so that we could complete the audit.

    I can’t speak for New Mexico but the processes I found in the 1990s were unbelievably archaic… they ran checks in a batch and often the checks were mangled in the printer. When this occurred, a staff person put a blank check in the typewriter, typed in all the amounts, and had “their friend” (this was her term, not mine) use the signature stamp on an adjacent desk and then they would send out this manual check instead of the mangled official one. There was literally nothing stopping them from writing out a check to themselves for a lot of money, stamping it with the signature machine on the desk, and then going out and cashing it. Theoretically the “audit” of the cash balances would have found it, but as you can see from the section above auditing out cash took years to do and was a very inaccurate, manual process. When I explained this process to my superior they couldn’t believe it (I was “causing trouble” again, just like I did when I documented the insane cash reconciliation process above) but since I carefully documented it they weren’t able to refute it. Doing things like this just made me more and more unpopular at the audit, of course.

    Another item that I found is that I attempted to reconcile their pension accounts on the books to the statements from the custodians. Of course there were major discrepancies here that I immediately noted; perhaps they had reasonable explanations but at this point in the audit the partner just took those papers away from me and scooted me out. They didn’t want me digging into anything else because who knows what I might find. We were being paid poorly in the first place and I was just generating more work; plus it wasn’t a good way to win future work by throwing a big new client under the bus (with issues such as this).

    You learn about your temperament for a job once you are doing it professionally; I started to learn that I was not good at 1) doing rote tasks in an unquestioning manner 2) accepting things at face value that made no sense to me (even if everyone else didn’t have a problem with it) 3) leaving aside problems or potential issues just because they were unfunded, painful, or politically difficult. The audit method back in the early 1990s was just to get the fee, get the job done, check the boxes, and get the heck out of there. I was not a good fit for this model for the reasons listed above (of course, if I was at a well-run company, perhaps I would have been on board with everything, but this never seemed to be the case) and I didn’t last too many years in auditing. They were glad to see the last of me, too.

    A lot has changed in audits in the 20+ years since this occurred and I assumed that a lot of things have changed for the better and that controls have been upgraded and standards for audits raised. But this New Mexico issue just brings me back to the early 1990s and perhaps my optimism is completely misplaced.

    Cross posted at LITGM

     

    21 Responses to “25 Stories About Work – The Difficulty of Verifying Cash”

    1. Carl from Chicago Says:

      I’m honored that “25 stories about work” is in the “notable discussion” category. There is a lot of great work in that category. Should inspire me to finish and get up to 25… I am on 17 now

    2. Lexington Green Says:

      The utter nightmare of this … .

      Tens of thousands of units of government, and how many of them (most?) are like this?

      Getting all of this online and subject to public scrutiny is absolutely essential.

    3. Mike K Says:

      The story reminds me of my Sears experience in 1958. The inventory of the warehouse was years behind and they had no idea what was in there. There is an interesting warehouse inventory story in “Once an Eagle” where Sam Damon, the Army officer, works for his wife’s cousin at a factory in 1929 while they are on leave.

    4. Veryretired Says:

      My late step-father, a very fine and hard-working man, was hired by a couple of public entities back in the 1960’s and70’s to bring their accounting systems up to snuff after they were forced to admit to auditors that they had no idea what their finances, among other aspects of their responsibilities, actually were.

      One major pension plan had no current accounting of who was getting the money, how much it was, and what their future liabilities would be. I remember he and my mother, who was his accounting control desk manager in these projects, sitting at the dinner table trying to understand how such a complete fiasco could have been allowed to develop over several years under several different administrators. It was not unusual for them to end up in almost hysterical, bewildered laughter as they tried to describe to each other the accounting or financial lunacies they had unearthed that day.

      One of my favorites was the widow who kept getting checks for her long deceased spouse month after month, even after she had been returning the checks for quite some time, along with letters asking that they stop, accompanied by copies of his death certificate. He found a file in some file drawer with a number of the checks and letters, all of which had just been shoved into a folder, filed, and forgotten, or, more likely, ignored because to rectify the matter was too much trouble.

      He left after a few years, having installed a new, computerized data and payroll system, and balanced the books down to a few mysterious dollars nobody could account for.

      He then went to work for a major museum and it’s art school, both of which had completely lost control of their data and accounting systems, and didn’t know what art they had and where it was, how many students were actually current enrollees and how much tuition they were paying, or if they were at all.

      Needless to say, their budget and other financial and insurance accounts were in a complete shambles. He did a job similar to the pension situation, installing a computerized accounting and inventory system, and helping the organization to satisfy the demands of some very unhappy auditors from its insurance carriers and bankers.

      I remember reading a few years ago about a GAO audit of the IRS that resulted in a very negative report, one major finding being that the revenue service had violated so many standard rules of accounting that if they had been a private entity, their entire management group would be under indictment, and the government would have seized their assets.

      As Instapundit frequently says, rules are for the little people.

    5. TMLutas Says:

      I get that verifying things can be difficult but how difficult is it to figure out that an accounting system is criminally bad? Is there a checklist of questions that would catch most of it?

    6. dearieme Says:

      I once had a disagreement with an accountant over how best to do an audit of a wine cellar. My idea was to lock the doors and check the bottles – preferably every bottle, or if that wasn’t practical, the high value bottles plus a random sample of the cheaper stuff.

      His idea was to look at the claimed inventory of the last “audit” and subtract from it the recorded outflows, and add the recorded inflows. That would give him his new inventory.

      In the end, the solution adopted was (i) sell much of the wine so that the problem was reduced in size, and then (2) do it my way.

    7. Michael Hiteshew Says:

      I doubt all the bad accounting is an accident or just laziness. They like it that way.

    8. Dan from Madison Says:

      Dearieme – I would have checked every bottle first, but I am a glutton for punishment that way. The accepted way to do it would be to check the expensive bottles and a random sample as you said, but the German in me can’t stand missing details. The trains must run on time, as they say.

      I tend to agree with Michael Hiteshew on keeping it cloudy. It would be extremely simple for any public entity to set up their accounting to track it down to the penny. Sure, the work to get it up and going would be mammoth, but after that, you are simply maintaining the data. I don’t think the government unions would like it if the sun came out on that particular patch of moss.

    9. Jeff the Bobcat Says:

      Another bane of an auditor’s existence is when a client goes through a computer or General Ledger conversion to a new system.

      I did an audit one time where this had happened and the biggest problem I found were the “Magic Entries”. I found these credit entries and asked the Controller where the other side (debits) of the entries were posted since it didn’t show on the General Ledger Posting Report. He said in a very tired voice, “Those are magic entries and don’t have debits”. I’m pretty sure I stared blankly at him for 10 or 15 seconds before I said in confusion, “What?”. He explained it a second and maybe third time. You see in double entry accounting you are required to have TWO sides to have a balanced legitimate entry, a debit and a credit. Their conversion to a new General Ledger had gone so badly that the software vendor had to build a way for them to post unbalanced entries so they could balance their books. Most people run both ledgers side by side for at least a short period of time to make sure everything was working properly, but they just flipped the switch from one system to the other one day. It was very difficult to rely on any of their financial reports since any account could be randomly adjusted to be whatever the end user desired.

      The end result was the audit ground to a halt, the Big Wigs all showed up and the client had to basically start from scratch with their financial records.

    10. Jim Miller Says:

      May I suggest a small editorial change? Replace that “exponentially higher” with something more accurate, mathematically. (A phrase using order or orders of magnitude would work.)

      (If my point isn’t obvious, try raising 100 to the .1 power.)

      I wouldn’t mention this, except that it is such a common mistake, coming, of course, from exponential growth. But an exponent doesn’t automatically make things much larger.

    11. pouncer Says:

      I instigated outside review of our local school district’s construction bond program. The process resulted in the takeover of the district by a state “conservator”, terminating the superintendent, and me running for and winning a seat on the local school board.

      Everything you can say about poor accounting practices showed up in one form or another during my three year tenure there. Just one quick example, we learned that the inventory value of copier paper or frozen fishsticks (at retail price per carton) was reported as part of our “current cash balance”. Even if it’s not “wrong” — it’s certainly confusing and unexpected for a board attempting to assess the health of the district.

      I confess my emotional health was not up to the effort of attempting to fix the problem. The attitudes and philosophy that created the situation was too deeply held; MY attitude was considered not merely different, or even wrong, but evil and destructive. So I got out of their way.

      And I recommend homeschool to anyone who will sit still and listen.

    12. Dan from Madison Says:

      Fishsticks = current cash – now that is funny.

    13. Jeff the Bobcat Says:

      Who doesn’t like fishsticks? You could barter them for something you need, like books.

      I’m guessing you wouldn’t be able to pay the teachers with them though.

    14. Michael Hiteshew Says:

      An article a few years back reported that an audit of the EU books resulted in several billion Euros unaccounted for. Funny that. Oddest thing. Where could it have gone? I’m sure any serious audit of US finances would turn up the same (or worse). You get enough money sloshing around between agencies and millions skimmed off here and there doesn’t even get noticed.

    15. pouncer Says:

      I have been assured that booking, as cash, the supplies that are regularly purchased, turned, “consumed” and replaced during the short term (two years or so) that they may be held in inventory is in accordance with the “yellow book” of generally accepted accounting principles as applied to cash-basis booked government entities.

      Was I misled?

    16. Carl from Chicago Says:

      These entities shouldn’t be on the cash basis, they are very large, they should be on the accrual basis.

      You are correct Jim on exponential… it probably is 1 1/2 to 2x the work.

    17. Mike K Says:

      My little city of Mission Viejo was a microcosm of the government in action. We had a city council that ran things as they pleased and took no advice. The city was only 20 years old so they had gotten very far down the road in a short time. Some residents formed a committee to try to reform the high handed city council. The history of the local reform group is here.

      We elected one council member who was ignored. Then we elected a second, a very nice lady who was one of those people who reads the city check register every month and wants to know what each item represents. The majority hated her. It got so bad that they would vote down every appointment she tried to make to city commissions. Finally, even though I didn’t know here, I was asked if I would agree to serve on the Planning Commission. I was approved because I had operated on one of the major council members so she felt she had to vote for me.

      The city manager, who resembled a mad bull and weighed over 200 pounds ultimately sued this councilwomen, who weighed about 100 pounds and had multiple sclerosis, for sexual harassment ! That was after he got fired by the new majority.

      Finally, we elected two more members so we had a majority on the council. Many new changes came about but one of the two new members made some new friends (Including the LA Times) and switched his positions. Another started voting according to who her friends in the city were.

      The reform group disbanded not long after. Reform is all about personalities and if you get the wrong ones, it collapses.
      Also, people lie when they are running for office. Who knew ?

    18. Carl from Chicago Says:

      Good for you at Mission Viejo.

      You definitely tried to fix things.

      It can be very hard.

    19. Mike K Says:

      We tried to fix things in a small city that was pretty prosperous but still middle class.

      We were undone by the fellow who decided we were suckers and who went his own way, toward influence and maybe some money of course.

      Democracy is tough. I like Walker like I liked Sarah Palin because they know about small government. The “Big Picture” people have no idea how to get things done. Reagan knew because he had negotiated contracts and dealt with the actors in SAG and the communists in Hollywood.

    20. ErisGuy Says:

      Frequent and massive government embezzlement without prosecution is proof laws against money laundering fail. If the crackpot, unnecessary, unworkable, and onerous rules about bank transaction succeeded, law enforcement officers would know who had the missing trillions.

      Most of law is show, an assurance that the world operates with a minimum of morality, but it’s only a facade. And can never be any other.

    21. Errolwi Says:

      New Zealand governmental entities changed to accrual accounting in the early 1990s. I had a 2 two year contract at a District Council (created from a merger of 4 Counties and 2 Boroughs as part of a nationwide restructuring at the same time) to assist in getting non-core areas set up in the new financial software (core stuff like property tax, payroll, payments were done as part of the merger).
      The main ‘discovery’ was just how bad the records relating to fixed assets get when places are operating under cash accounting rules.