GUIDE TO ETHICAL GOVERNMENT SPENDING Living in a Glass House Michael A. Crawford, CPA

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GUIDE TO ETHICAL COVERNMENT SPENDING

A publication by Michael A. Crawford, CPA of Crawford & Associates, P.C., designed to promote ethics, transparency and

accountability in government spending

Crawford & Associates, P.C. 10308 Greenbriar Place

Oklahoma City, OK 73159 T 405-691-5550 F 405-691-5646

W www.crawfordcpas.com E mike@crawfordcpas.com

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GUIDE TO ETHICAL GOVERNMENT SPENDING

Table of Contents PREFACE........................................................................................................................................... 5

ABOUT THE AUTHOR ....................................................................................................................... 7

CHAPTER 1 – SETTING THE RIGHT ETHICAL CLIMATE ..................................................................... 8

Establishing and Maintaining the Right Ethical Environment ..................................................... 8

Establishing a Proper Code of Conduct ....................................................................................... 9

Principles of Government Ethics ........................................................................................... 10

Stressing the Importance of Integrity in Public Service......................................................... 10

Addressing Ethical Dilemmas .................................................................................................... 12

Steps to Resolving Ethical Dilemmas ..................................................................................... 13

CHAPTER 2 - DEFINING AND RECOGNIZING WRONGFUL SPENDING ............................................ 17

Illegal Acts .................................................................................................................................. 17

Fraud .......................................................................................................................................... 21

Abuse ......................................................................................................................................... 22

Waste ......................................................................................................................................... 23

CHAPTER 3 - PREVENTING AND DETECTING WRONGFUL SPENDING ........................................... 25

Establishing and Implementing Internal Controls ..................................................................... 25

What Internal Control Is ........................................................................................................ 25

What Internal Control Is Not ................................................................................................. 25

Designing an Effective System of Internal Control ................................................................ 26

Establishing Key Controls over Wrongful Spending .............................................................. 28

Identifying and Addressing Fraud Risks ..................................................................................... 29

Identifying Red Flags in Fraudulent Spending ....................................................................... 31

Tips for Preventing or Detecting Fraud ................................................................................. 32

Applying Professional Skepticism .............................................................................................. 34

CHAPTER 4 - REPORTING INDICATIONS OF WRONGFUL SPENDING ............................................. 37

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Exercising Moral Conviction and Courage ................................................................................. 37

Providing for Effective Lines of Communication ....................................................................... 37

Establishing an Ethics Hot Line .............................................................................................. 38

Establishing a Whistleblower Policy ...................................................................................... 40

Establishing an Ethics Board or Committee .......................................................................... 41

Establishing an Effective Audit Committee ........................................................................... 42

CONCLUSION ................................................................................................................................. 44

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PREFACE Spending government resources is like “living in a glass house.” All your actions and

activities are open to and scrutinized by others as evidenced by the laws and regulations

related to open meetings, open records, and freedom of information. The use of

“involuntary” public resources demands a transparent approach to accountability. These

principles of transparency and accountability for the use of public resources are

essential to our nation’s governing processes and to maintaining public trust. A 1978

Oklahoma Supreme Court ruling maybe said it best by stating that

“If an informed citizenry is to meaningfully participate in government or at least

understand why government actions that affect their daily lives are taken, the

process of decision making as well as the end results must be conducted in full

view of the governed.”

Government officials are entrusted with public resources and are responsible for

carrying out public functions efficiently, effectively, economically, and ethically, while

achieving desired program objectives and providing public services. Those who govern

and those who are governed need to be assured that (1) the government manages its

public resources and uses its authority properly and in compliance with laws and

regulations; (2) the government’s programs and services are achieving their objectives

and desired outcomes; (3) the government’s services are provided effectively,

efficiently, economically, and ethically; and (4) government managers are held

accountable for their use of public resources. Therefore, it is essential that government

officials and employees embrace the concepts of transparency and accountability for

their use of public resources.

Wrongful spending or the perception of wrongful spending through lack of transparency

can be the downfall of public trust. In this document, we will explore the concepts

associated with promoting ethical government spending including (1) how to establish

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the right ethical climate within the government organization (2) how to define and

recognize wrongful spending, including illegal acts, fraud, abuse, and waste, (3) how to

prevent or detect wrongful spending through a system of internal control and

organizational fraud awareness, and (4) how to effectively report or communicate

indications of wrongful spending.

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ABOUT THE AUTHOR

Michael A. Crawford is a Certified Public Accountant and Chairman Emeritus of Crawford & Associates, P.C., a CPA firm headquartered in Oklahoma City, Oklahoma, that specializes in providing professional services exclusively in the practice area of state and local governments. Mr. Crawford is a former auditor and consultant for an international accounting firm, a former finance director for a municipal government and has over 32 years of experience working with governmental entities. He is a past president of the Oklahoma Society of CPAs, an inductee into the Oklahoma Accounting Hall of Fame, and a past Vice Chairman of the Governmental Accounting Standards Advisory Council (GASAC), and Chair of the GASAC Technical Agenda Committee. Mr. Crawford is a nationally recognized author and public speaker, and is responsible for the development of a number of CPA publications and practice aids on governmental accounting, auditing and ethics.

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CHAPTER 1 – SETTING THE RIGHT ETHICAL CLIMATE

Establishing and Maintaining the Right Ethical Environment

The “tone at the top” of an organization generally establishes the overall attitude

toward ethics (ethical climate) within that organization. In other words, if you expect

employees and others within the government to behave ethically, then the governing

body, management and other government leadership must “walk the talk”, and set the

right example for others to follow.

Creating the right ethical climate is not the same as having a documented code of ethics

or conduct within the government. Many of governments and other organizations that

have been victimized by scandal and ethical lapses, have had well documented codes of

ethics and conduct. However, in these governments or organizations, management, the

governing body, or both of these groups have failed to incorporate the elements of

these codes into their overall organizational culture. To create a positive ethical climate,

a government organization must understand the ethics-based risks associated with its

activities, and provide for an environment that encourages the proper behavior and

decision-making in response to these risks. An ethics-based risk can be defined as the

risk that the governing body, management, or staff will not know how to respond when

faced with a specific ethical dilemma. It is not sufficient to merely have a documented

code of conduct. The government’s leadership must foster a culture that can withstand

the ethics-based risk pressures it is likely to face and uphold the principle of integrity

when dealing with the challenges posed by those pressures.

Setting the right ethical climate involves such actions as:

• Conducting open meetings with transparency, integrity, fairness and respect and

honoring the form and spirit of open records requirements

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• Creating a positive and open work environment that encourages moral behavior

and communication of inappropriate behavior, including providing hot lines for

anonymous tips and whistleblower protection

• Hiring employees committed to maintaining the right ethical environment

• Establishing, communicating, and enforcing a comprehensive code of conduct

• Developing an anti-fraud policy that includes fraud awareness and prevention

training, reporting and investigative processes, and resolution or results of

confirmed fraud

• Guiding employees in navigating through the “gray” areas where no specific

laws, regulations, policies, or guidelines exist

• Providing employee counseling and assistance programs for employees

experiencing work or personal problems

• Enforcing the code of conduct by rewarding demonstrations of moral courage,

and by effectively punishing instances of unethical behavior

Without the governing body and management setting the right ethical example for the

entire government through their own actions and through creating the right

organizational environment, employees will be less likely to follow the appropriate

ethical path when faced with moral dilemmas. The governing body and management’s

actions are more powerful than words!

Establishing a Proper Code of Conduct Every government entity or agency should have a formal code of conduct in place and

take the steps necessary to ensure it is well communicated to and reinforced with its

governing body, management, and staff. Ideally the code of conduct should be

introduced to all new officials and employees upon joining the organization and then

reinforced through period training and staff meetings.

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Principles of Government Ethics

In establishing and maintaining a proper ethical environment within the government,

the following ten principles should form the cornerstone of the code of conduct and

expected behavior:

1. Public service is about public trust, not about private gain

2. Avoid conflicts of interest in fact and appearance

3. Don’t misuse or misappropriate government information, funds or property

4. Don’t accept or solicit gifts or items of value

5. Put forth honest effort in duties

6. Make no unauthorized or unfulfillable promises or commitments

7. Be impartial and avoid giving preferential treatment

8. Exercise civility and respect others opinions and beliefs

9. Comply with laws and meet all obligations as any other citizen

10. Expose corruption and report fraud, waste and abuse

These principles should be included and defined in understandable detail within a

formal written code of conduct that is provided to all government officials and

employees and reinforced through periodic training and application.

Stressing the Importance of Integrity in Public Service

Integrity is an essential element of character fundamental to the government or public

service. It directly affects the level of public trust afforded the government and elected

or appointed representatives and should be the benchmark against which a government

official or employee must perform. Integrity requires an individual to be, among other

things, honest and candid within the constraints of required confidentiality. Service and

the public trust should not be subordinated to personal gain and advantage. Integrity

can accommodate the inadvertent error and the honest difference of opinion, but it

cannot accommodate deceit or subordination of principle. Integrity is measured in

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terms of ethical decision making or what is morally right and just. In the absence of

specific laws, rules, policies, or guidance or in the face of conflicting opinions, an

individual should apply ethics by questioning his or her own actions based on the

public’s expectations (i.e. what does the public deserve and expect). Integrity requires

an individual to observe both the form and spirit of laws, rules, policies, or guidance. In

observing both the form and the spirit of laws or other legal requirements, it is

important to understand that simply because an action may not be illegal, this does not

mean that the action is ethical or the right thing to do. The fact that it is possible or legal

to do something does not mean that it ought to be done. Laws establish a minimum level

of prudent behavior that must be followed in society. However, applying ethics involves

moral considerations, beyond the laws, and requires consideration of a higher level of

prudent behavior. The application of appropriate moral behavior takes into

consideration not only the legal requirements or ramifications related to an action, but

also the individual’s moral obligation to the public and others in determining the proper

action to take.

PRACTICAL EXAMPLE: Assume that a president of state university has

just recently been hired and is in the process of renovating the university-

owned president’s house on campus. The president’s house currently has

three televisions that average being five years old. During the renovation,

the president determines that these televisions are not large or new

enough, and that more televisions are needed. The president then directs

staff to purchase seven new high-definition flat screen televisions for the

house, essentially one for each room of the house, including the master

bathroom. These televisions are purchased with university resources and

will become university property. As a result, these purchases are not

considered in violation of any constitutional provision, statute, or

regulation. However, while acquiring all these new high-definition flat

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screen televisions for the president’s house may not represent an illegal

act, the action lacks sufficient ethical consideration for the appropriate

use of the institution’s public resources. While it may be legal to make

these purchases, it is not appropriate behavior from a moral perspective

because the end result of the action is to detract or divert resources from

the primary educational objectives of the institution for the personal

benefit of the university president and family.

Addressing Ethical Dilemmas

Trying to understand and predict human behavior is complex at best and involves a wide

range of philosophical theories and concepts upon which even professional

psychologists often disagree. However, one thing is for certain, certain decisions in work

and life are difficult to make. Quite often, these decisions involve ethical dilemmas. An

ethical dilemma can be described as a situation that calls for some type of action, where

an individual may be simultaneously compelled and pressured to take different

alternative actions. These compelling reasons or pressures to take different actions

compete against one another, thereby creating the ethical dilemma.

For example, assume you are a member of the governing body of a local government

and are made aware of a group of citizens who are in desperate need of funds to

provide financial help for a family that has recently lost their home in a fire. This group

has approached you as a local government official and asked for a donation of public

funds to assist in their efforts for the immediate and long-term benefit to the family (a

compelling reason to make the donation). However, you are informed by the

government’s legal counsel that such a donation could be considered a violation of the

state constitution on the use of public funds (a compelling reason to not make the

donation). Hence an ethical dilemma - compelling reasons or pressures to take different

actions that compete against one another.

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Steps to Resolving Ethical Dilemmas

When faced with an ethical dilemma, morally poor choices are usually made for one of

three reasons:

1. Individuals do what is most convenient.

2. Individuals do what they must to succeed.

3. Individuals rationalize their choices with situational ethics.

Government officials and employees must avoid the temptation of giving into these

three reasons when faced with ethical dilemmas, and instead must demonstrate the

moral courage and bravery to stand up for what is right.

Individuals should be provided the proper training and guidance in ethical decision

making to overcome the temptations that surround making morally poor choices. In

facing tough ethical dilemmas, you should consider the following five-step approach or

process:

1. Gather all the relevant facts regarding the situation or circumstance.

2. Consider what alternative actions are available.

3. Consider the applicable external laws, regulations, principles, rules and internal

policies and procedures (justice considerations - what is the right thing to do

from a legal, rules or principles perspective).

4. Consider the results or consequences in terms of good versus harm that may

result from the alternative actions (care considerations - what is the right thing

to do in terms of helping others or benefiting the most people).

5. Select the course of action that upholds the core values of honesty, respect,

responsibility, fairness, and compassion, and takes into account both justice and

care considerations; reflect on that decision; and exercise moral courage to face

and endure the challenges or dangers that may be associated with your decision.

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PRACTICAL EXAMPLE:

Step 1 - Gather the Facts: An elected state audit official is responsible for

auditing health agencies within the state that receive state funding. One

such group of health agencies are owned and operated by a prominent

citizen who has been a long-time friend of the state audit official. The

health agencies’ owner and the state audit official have both a personal

and professional relationship, although the professional relationship is

relatively new and only began when the state audit official was elected.

For years, they have been friends and played golf together, belonged to

the same country club, and frequently gone on vacations together. In

regards to business and audit matters, they serve as the primary contacts

between their two entities on all matters of significance. The state audit

official has not yet performed any audits over his friend’s health agencies,

but such audits are planned for later in the year. In an expression of

appreciation of his continued friendship, the health agencies’ owner has

offered to take the state audit official and spouse on an all-expense paid

five-day trip to Las Vegas. Under these circumstances, what actions

should the state audit official take?

Step 2 – Consider Alternative Actions: Alternative actions could include

1. Accept the trip as offered.

2. Go on the trip provided the state audit official pays for his or her share

of the costs.

3. Decline to go on the trip under any circumstances.

Step 3 – Consider Applicable Laws, Principles, Rules, and Policies:

Assume, that the professional ethics standards applicable to the state

audit official requires the auditor to maintain objectivity and integrity,

and be free of conflicts of interest, and that his or her objectivity would

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be considered impaired by accepting or offering gifts or entertainment

from or to a client, unless the gift or entertainment was “reasonable” in

the circumstances. In determining “reasonableness in the

circumstances,” the auditor should consider such factors as: (1) the

nature of the gift or entertainment, its cost or value, and the occasion

giving rise to the gift or entertainment, (2) the nature, frequency, and

value of other gifts offered or accepted, (3) whether the entertainment

was associated with the active conduct of business either directly before,

during, or after the entertainment, (4) whether other clients, customers,

vendors, or employees of the company or firm also participated in the

entertainment. In addition, assume that applicable state laws and

regulations prohibit the receipt of gifts or “things of value” in excess of

$100 in any one year from any lobbyist or individual in a position to

exercise influence over the elected official.

Step 4 – Consider the Results and Consequences in Terms of Good

versus Harm: From a personal perspective, in accepting the all-expense-

paid trip, the state audit official and spouse would be the recipients of a

potentially enjoyable cost-free vacation. However, from a negative

consequences perspective, the state audit official could be placed in a

position where his friend would expect a professional favor in return in

the future, including a finding-free audit. It is likely that if the state audit

official paid for all his or her expenses on such a trip, that it would not be

a violation of the applicable state laws. However, if the public were to

merely perceive a conflict of interest in this relationship, the credibility

and reliability of the future audit results could be reasonably questioned

and damage could be done to the public’s trust in the state audit office.

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Step 5 - Select the Most Ethical Course of Action: All too often, gifts

and entertainment of this nature and value involve the perception of

giver expectations of receiving something in return. The pressure from

these expectations, when coming from auditees, could be of such

magnitude to negatively affect the objectivity of the audit official.

Although, this trip may be similar to previous trips taken together by the

health agency owner and the state audit official before the audit official

was elected, there still exists the danger associated with the perception

of a conflict of interest, and such a perception would damage the

credibility of the auditor and the public’s trust in the audit office.

Therefore, under these circumstances, it would be in the best interest of

the state audit official, the health agency owner, and the public for the

state audit official to decline the trip entirely.

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CHAPTER 2 - DEFINING AND RECOGNIZING WRONGFUL SPENDING

Wrongful spending in government can be defined as spending that involves elements of

any of the following:

• Illegal Acts

• Fraud

• Abuse

• Waste

These elements are defined below, including examples of improper spending or

inappropriate behavior.

Illegal Acts

From the perspective of government spending, illegal acts can be defined as acts related

to purchasing, contracting, and paying for goods and services that are in violation of

governmental laws and regulations, including provisions of constitutions, charters,

legislative acts (laws), resolutions, and other regulatory requirements.

Examples of Illegal Acts:

With regards to government spending, the following are examples of potential illegal

acts, depending on the facts and circumstances:

a. Using government property or resources for personal or non-public purposes

b. Gifting, donating, or loaning public resources to private individuals,

organizations, or corporations without a contract for service

c. Failing to follow competitive bidding requirements when required, or splitting

purchases to avoid competitive bidding requirements

d. Accepting gifts or kickbacks for providing favors or special considerations

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e. Authorizing purchase commitments or contracts in excess of available

appropriation or other legal spending limit

f. Failing to pay overtime and other compensation to employees in accordance

with the requirements of the federal Fair Labor Standards Act, where applicable

g. Using legally restricted resources for purposes other than the restricted

purposes specified in the legal requirement

h. Failing to account for and spend certain restricted resources in separate funds as

may be required by law

Each state or local government entity may have differing legal requirements in regards

to spending and use of public resources. For example, at a very high level, the State of

Oklahoma Constitution contains the following provisions regarding the use of public

resources:

• Public Purpose Limitation (Article 10, § 14 A.) - Except as otherwise provided by

this section, taxes shall be levied and collected by general laws and for public

purposes only…

• State Prohibition on Aid to Others (Article 10, § 15 A.) - Except as provided by

this section, the credit of the State shall not be given, pledged, or loaned to any

individual, company, corporation, or association, municipality, or political

subdivision of the State, nor shall the State become an owner or stockholder in,

nor make donation by gift, subscription to stock, by tax, or otherwise, to any

company, association, or corporation.

• Local Government Prohibition on Aid to Others (Article 10, § 17) - The

Legislature shall not authorize any county or subdivision thereof, city, town, or

incorporated district, to become a stockholder in any company, association, or

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corporation, or to obtain or appropriate money for, or levy any tax for, or to loan

its credit to any corporation, association, or individual.

PRACTICAL EXAMPLES: In regards to the above noted Oklahoma State

Constitutional provisions on use of public resources, the following

actions could be considered a constitutional violation:

• Spending public resources on improvements to a personal

residence or vehicle of a government official or employee (a non-

public purpose)

• Spending public resources or using public employees to improve

private property (a non-public purpose)

• Donating public resources to a local non-profit organization

without a contract for services (donating or gifting of public

resources)

• Using public resources to purchase the capital stock of a local

emerging business (becoming a stockholder in a company or

corporation)

• Loaning public resources to a local chamber of commerce to be

repaid when the chamber receives anticipated grant funding

(loaning the credit of the government to a corporation or

association)

• Advancing paid sick leave to an employee prior to the employee

earning the leave or being entitled to it (loaning the credit of the

government to an individual)

(Note: Whether these examples are in fact an illegal act, is a matter of

legal determination by a court of law. They are listed here as possible

illegal acts for purposes of demonstrating the application of

constitutional limitations to governmental spending. For example, a

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government might legally provide tax incentives, or otherwise commit or

use public resources in a manner that will ultimately benefit a private

individual, association, or corporation under the theory that it is

benefiting the public as a whole in terms of community development or

economic development. Therefore, legal counsel should always be

consulted on matters that involve the potential to be perceived as an

illegal use of public resources.)

A word of caution though…In addition to the overriding constitutional constraints on

spending, each individual government or government agency may have more specific

laws and regulations that should be followed that may be more restrictive or provide

additional spending constraints. These other legal requirements could be in the form of

state laws, state regulations, local charters, and local ordinances or resolutions.

PRACTICAL EXAMPLE: While a municipal government may be subject to

the broad spending restrictions contained in a state constitution to which

it is subject, the municipality may also be governed by a local charter that

contains a specific provision that limits contracting to only local vendors

when the desired goods or services are available locally. Furthermore,

the municipal governing body may have also adopted an ordinance (local

law) that requires all purchases over a specific dollar amount to be

approved in advance by the governing body prior to the purchase

commitment. Therefore, the municipality must be familiar with and

comply with all applicable legal requirements.

A significant amount of legal research may be needed to develop a complete and

comprehensive list of spending laws and regulations to which the government is subject.

Such as listing should become a permanent part of the government’s purchasing and

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spending policies and procedures and should be continuously updated as new laws and

regulations are established or existing ones are modified.

Fraud

Fraud can be broadly defined as an intentional deception or perversion of the truth

made for personal gain or to damage another individual. Fraud from the perspective of

government spending can be defined as the spending activities or actions that are

intentionally designed to deceive another party, and can involve embezzlement of

government monies, filing false claims, and contract fraud.

Fraudulent activities can be categorized by type of perpetrator as:

• Internal fraud – activities perpetrated within the organization (e.g. employee

theft or embezzlement, misappropriation of resources, intentional

misstatements in financial reports)

• External fraud – activities perpetrated by individuals outside the organization

(e.g. false claims or statements provided to the government, fraud by

beneficiaries of government benefits, contract or procurement fraud by vendors

or contractors)

• Internal and external fraud – activities perpetrated by government employees

and outsiders in collusion (e.g. kickbacks to employees from vendors or

contractors for preferential treatment)

Examples of Fraud:

With regards to government spending, the following are examples of fraud, depending

on the facts and circumstances:

a. Splitting contracts or purchases in an effort to avoid competitive bidding

requirements

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b. Awarding a contract to someone other than the lowest and best bidder for

reasons of personal gain or to do damage to another party

c. Falsifying purchasing, receiving, or payment documents to conceal the

misappropriating or embezzling of public resources for personal gain

d. Approving purchase documents or contracts with knowledge that no

appropriation is available for that purpose or that it will exceed available

appropriation

e. Miscoding a purchase order or invoice for the purposes of avoiding budget

overages or the exceeding of legal appropriations

f. Falsifying or omitting key information in employment applications or

employment tax documents

g. Falsifying time worked or leave earned/taken in payroll time records

h. Submitting a false request for paid sick leave when the employee is not actually

sick

Abuse

Abuse involves behavior that is deficient or improper when compared with behavior

that a prudent person would consider reasonable and necessary business practice given

the facts and circumstances. Abuse includes misuse of authority or position for personal

financial interests or those of an immediate or close family member or business

associate. From the perspective of government spending, abuse can involve

unreasonable or unnecessary spending or purchases that are unnecessarily extravagant

or expensive. Actions and activities do not need to be illegal or fraudulent to be

considered abusive.

Examples of Abuse:

With regards to government spending, the following are examples of abuse, depending

on the facts and circumstances:

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a. Creating and paying for unneeded overtime

b. Requesting staff to perform personal errands or personal work tasks for a

supervisor or manager

c. Misusing the official’s position for personal gain, including actions that could be

perceived by an objective and knowledgeable third party as improperly benefiting an

official’s personal financial interests or those of an immediate or close family

member, or that of an organization owned by or other benefitting the official

d. Making travel choices that are contrary to existing travel policies or are

unnecessarily extravagant or expensive

e. Making procurement or vendor selections that are contrary to existing policies or

are unnecessarily extravagant or expensive

Waste

Waste in government spending is much more difficult to define that illegal acts, fraud,

and abuse. Identifying wasteful spending involves the application of significantly more

judgment than in cases of illegal acts, fraud, and abuse. Often different individuals will

have varying perspectives on defining what is wasteful. However, generally speaking

government spending waste can be defined as “the inefficient or ineffective use of

public resources.”

Examples of Waste:

The following are examples of waste, depending on the facts and circumstances:

a. Spending public resources on pork-barrel projects

b. Spending on ineffective projects

c. Spending on duplicate projects or activities

d. Spending on payroll where duties are neglected or excessive unproductive work

hours are charged

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With an understanding of the types of wrongful spending that can occur in government,

an individual is better prepared to determine “what can be done to better prevent, or

detect and report such actions or activities” in achieving the ultimate goal of protecting

public resources and maintaining public trust. The remaining chapters of this guide will

deal with the issues of prevention, detection, and reporting or potential wrongful

spending.

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CHAPTER 3 - PREVENTING AND DETECTING WRONGFUL SPENDING

Establishing and Implementing Internal Controls

The key to preventing and detecting wrongful spending lies in the proper design and

implementation of a system of internal control. A system of internal control is put in

place to keep the organization on course toward its goals and achievement of its

mission, and to minimize surprises along the way.

What Internal Control Is

Internal control is broadly defined as an entity’s process, affected by the entity’s board,

management, and personnel, designed to provide reasonable assurance regarding the

achievement of certain objectives. In the context of financial management, these

control processes should provide reasonable assurance that reliable and fairly presented

financial statements will be prepared, financial-related laws and regulations will be

complied with, and assets will be adequately safeguarded. In the specific context of

government spending, internal control processes should provide reasonable assurance

that spending-related laws and regulations will be complied with, and public resources

are used efficiently and adequately safeguarded against misuse and misappropriation.

What Internal Control Is Not

Internal control is not a panacea. The internal control process can help an entity achieve

its objectives. However, no matter how well designed and implemented it can only

provide reasonable, not absolute, assurance of achieving those objectives. For example,

although controls may be adequately designed and in place, control objectives may still

be unachieved resulting from: (1) simple errors and mistakes, (2) faulty judgments in

decision making, (3) circumvention by collusion, and (4) management override of

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controls. Finally, the design of internal controls must be considered within the context

of resource constraints and cost effectiveness.

Designing an Effective System of Internal Control

Internal control processes can generally be classified into one of the following five

components of an integrated internal control framework:

1. Control environment - the tone of the organization influencing the control

consciousness of its people, such as a well-communicated and understood code

of conduct, an effective management style, and a demonstrated interest in

controls by the governing body

2. Risk assessment - the identification and analysis of relevant risks to achieving the

control objectives, such as risks of noncompliance with legal spending

requirements, and risks of misappropriation of assets for personal use

3. Control activities - policies and procedures that help ensure actions are taken to

address the identified risks, such as effective policies and procedures related to

the authorization and processing of purchase orders, invoices, and payments for

goods and services

4. Information and communication - the information and communication systems,

both manual and automated, that make it possible to operate, control, and

report the entity’s activities, such as an effective information technology system,

sufficient internal and external reporting systems, and proper channels of

internal and external communications

5. Monitoring - the on-going monitoring and evaluation of the effectiveness of the

other four components of the internal control framework through internal and

external audit activities and governing body and management oversight; a well

recognized system of monitoring can also be an effective deterrent to wrongful

spending

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For internal controls to be properly designed and operating effectively, each of these

five integrated elements must be working together. The evaluation of the effectiveness

of the design and operation of internal controls should be focused on the identification

of control objectives, the specific risks associated with achieving those objectives, and

the internal controls designed to minimize those risks. In other words, you should define

(1) “what we want to accomplish”, (2) “what could go wrong”, and (3) “what we should

do about it”.

PRACTICAL EXAMPLE: One of the objectives of internal control over

wrongful spending (what we want to accomplish) is to ensure that

purchase commitments and contracts are made in conformance with

applicable laws and regulations, such as competitive bidding laws and

public-purpose laws. When evaluating the effectiveness of internals with

regards to this control objective, you could consider what specific risks

exist that could result in not achieving the compliance objective (what

could go wrong) and then identify the internal controls needed to

minimize those risks (what we should do about it). This process is

illustrated in the table below.

Control Objective (what we want to accomplish): Ensure that purchase

commitments and contracts are made in conformance with applicable laws and

regulations.

Specific Risks (what could go wrong) Controls to Minimize the Risks (what we

should do about it)

Laws and regulations are

unintentionally violated because

Individuals involved in the purchasing

process are not aware of the applicable

laws and regulations.

1. Up-to-date policies and procedures,

including reference to laws and

regulations, are written and provided to

purchasing staff.

2. Entity management and staff are

provided periodic training on laws and

regulations and related policies and

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procedures.

Laws and regulations are intentionally

violated or policies and procedures are

circumvented for personal gain.

1. Duties are segregated between

purchase authorization, receiving, and

payment approval.

2. Entity management and governing

body provide oversight of purchases in

excess of a specific dollar amount in an

effort to monitor compliance.

Employees with knowledge or suspicion

of laws and regulation violations do not

communicate or report such concerns.

1. Entity has a code of conduct and

related policies and procedures in place

to encourage the reporting of

noncompliance with laws and regulations

to appropriate persons, and provides for

whistleblower protection.

2. Entity has an effective internal audit

function or similar internal investigative

unit that follows up on such reported

concerns.

It is important to note that in the above example, risks of not achieving the control

objective of laws and regulations compliance are addressed with internal control

processes that “specifically respond to each risk.” This approach to identifying and

addressing specific risks is the most effective way to prevent and detect wrongful

spending in government from the perspective of the design of internal controls.

Establishing Key Controls over Wrongful Spending

While the design and implementation of an effective system of internal control requires

a thorough evaluation of control objectives and risks, there are certain broad types of

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controls (key controls) that should be considered over wrongful spending. These key

controls include:

• Authorization and Approval – controls over spending that involve delegation of

authority with specified limitations and approval requirements (e.g. identifying

who is authorized to make certain purchases, setting limits where advance

approval is needed, indicating who must review and sign documents for

evidence of approval)

• Security over Access – controls over access to purchase authorization documents,

signature stamps, cash, checks, and computer system processes that safeguard

assets from loss or misappropriation (e.g. maintaining locked safes, cash

drawers, and frequently changing computer access codes)

• Segregation of Duties – controls that do not put a single individual in a position

to be able to commit a fraud or misappropriate resources and then be able to

conceal it (e.g. preventing the same individual from placing an order for goods or

services, acknowledging the receipt of those goods, and authorizing payment)

• Review and Oversight – controls that provide sufficient monitoring over spending

activities, the reconciliation and investigation of unresolved questions or

differences, and the ultimate resolution of those questions or differences (e.g. a

timely comparison of budget and actual amounts to look for unexplained

variances, and periodic internal audits over spending activities)

Identifying and Addressing Fraud Risks

Identifying fraud is difficult because unlike identifying errors in judgment or application,

fraud involves an attempt to conceal. Therefore, it is important to be alert to certain

conditions that may be present in your organization that could heighten the risk of

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fraudulent activity. Popular guidance in the area of fraud awareness indicates that most

frauds contain all of the following three elements:

1. Motive or Pressure – the reason an individual decides to engage in fraudulent

behavior

Examples:

• Unmanageable personal financial obligations

• Excessive gambling or other addictive vices

• Adverse employment relationships

• Living beyond one’s means

2. Opportunity – the condition that provides an individual the ability to perpetrate

the fraud

Examples:

• Unrestricted access to cash or other assets

• Inadequate segregation of incompatible duties

• Inadequate monitoring or oversight

• Records are in disarray and difficult to follow or trace

3. Rationalization – the mindset of the individual that allows him or her to justify

fraudulent actions

Examples:

• Employee displeasure or dissatisfaction with job or compensation, or

revenge for unfair treatment

• Just a temporary borrowing that will be paid back

• Everyone does it, it is no big deal

• No harm, no foul

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To enhance your ability to identify fraud in your organization, you must understand

these three elements and constantly be alert for evidence of their existence and watch

for warning signs (red flags) of potential fraud.

Identifying Red Flags in Fraudulent Spending Indicators of heightened risk of government spending fraud could include the following

red flags that should not be discounted or overlooked:

• Employees are scared of superiors and there is evidence of management

override, in other words management bypassing controls or overriding lower-

level decisions for personal gain

• Employees do not take or refuse to take vacations or extended periods of time

off

• Employees with fraud opportunities exhibit evidence of fraud motives or

pressures, such as unusual behavior, personal financial problems, excessive

gambling, living beyond their means

• Payments are made to unfamiliar employees or terminated employees

• Employees carry unusually high unused leave balances

• IRS notices for untimely tax deposits or failure to make required deposits

• Non-existing or unapproved employee time records or leave requests

• Unsupported expense reports or reports with excessive or unreasonable

expenses reported

• Travel and training expenditures are significantly increased or in excess of

budget

• Key purchasing or payment documentation is lacking or does not exist, such as

no evidence of receiving advices

• Invoices are faxed, only in photocopy form, or appear altered

• Vendors have only post office box addresses

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• Contracts or invoices are in amounts just under the dollar threshold that would

require bidding or pre-approval

• Invoice numbers are in broken sequence from the same vendor

• Vendor names are similar to each other, or may have the same address or phone

number

• Certain purchasing or payment documents or transactions are subjected to

“special” handling outside the normal policies and procedures

• Excessive use of sole source purchases

• Certain vendors appear to consistently obtain all or an extraordinary share of the

business

• Certain purchases appear to contain unreasonably high prices or significantly

lower quality when compared to other competition

• Vendors and government employees with purchasing authority have close

personal relationships or frequently dine together or otherwise socialize

• There is a pattern of large procurements in any budget line with remaining funds

at year end, in order to “use up all of the funds available”

• Tips or complaints regarding wrongful spending or fraud are ignored or not

followed up on

When any of these fraud red flags are present, they must not be ignored or overlooked.

Appropriate follow up is needed to ensure they are not indicators of an actual fraud.

Tips for Preventing or Detecting Fraud

Even the best of internal controls may not be sufficient to prevent or detect fraudulent

activities because the individual(s) perpetrating the fraud are also doing their best to

conceal the fraud. Therefore, it is especially important to be alert to identify potential

fraudulent activities. The following guidance will help you be more alert to potential

fraud and enhance your ability to prevent or detect fraud.

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1. Just Going through the Motions – avoid the work mentality of just doing the

steps in a process without thinking about what you are doing; supervisors should

reinforce with employees the need to pay attention to their tasks and the

consequences for failure to be responsible in carrying out those tasks

2. See No Evil, Hear No Evil – avoid putting blind trust in any individual, thereby

failing to recognize or acknowledge fraud warning signs or red flags; realize that

anyone can commit fraud, and when faced with warning signs prove to yourself

that it is not fraud

3. It’s Good to be the King – look out for positional immunity, or in other words,

upper level management or the governing body rationalizing that rules or

controls don’t apply to them because of their position; these conditions

generally present themselves as management override of existing processes or

controls; identify someone within or outside the organization to whom you can

report such activities with jeopardizing your job

4. New Kid on the Block – don’t give in to the thinking that new employees are not

yet competent in their position and therefore not in a position to question why

certain things are happening; new employees are generally not prejudiced by

past policies, procedures, and practices; supervisors should take all employees

questions seriously, and employees doing the questioning should address their

question to more than just a single individual

5. Where’s All the Time Gone – beware of the pitfalls of excessive workload and do

not use this excuse to rationalize why designed internal controls cannot be

followed; for example, it may take more time to reconcile differences noted in

purchase documents, but that reconciliation is essential to managing fraud risks;

when faced with an excessive workload, reevaluate assignment of duties, and if

necessary demand more resources by explaining the consequences of fraud

6. Don’t Invade my Space – beware of employees who do not want any other

individual performing their tasks or learning what they do; encourage cross-

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training, periodic rotation of duties, and mandatory vacations for all employees

and positions

7. Must Not Be for my Eyes – be concerned when you are denied access to

requested records that support the work to which you are assigned; report such

activities and lack of openness to appropriate supervisors and do not give up on

the unfulfilled request

8. It’s None of my Business – don’t look the other way when faced with signs of

fraudulent or unethical behavior by rationalizing that the activities are none of

your business; work to create an environment within the organization that

fosters ethical and responsible behavior and the reporting of lapses in such

behavior

9. It’s Over my Head – avoid the failure to question activities, events, or

transactions that appear unusual because you feel you do not fully understand

the situation or circumstances; individuals involved in fraudulent activities often

rely on the complexity of the circumstances to help them conceal such fraud;

continue to educate yourself, and ask for simplification in reports and

explanations

10. Just a Bad Apple in the Bunch – realize that even with the best of internal

controls, some people are just “ethically challenged” and are looking for ways to

commit fraud or improperly benefit themselves or gain an advantage; do your

due diligence in hiring employees and learning as much as possible about their

background and ethics

Applying Professional Skepticism

An important aspect of identifying wrongful spending is maintaining and applying a

sense of professional skepticism throughout the spending process. Professional

skepticism is an attitude that includes a questioning mind and a critical assessment of

motives and documentation/evidence. In applying professional skepticism, you should

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have a mindset that recognizes the possibility that a fraud could be always present,

regardless of your past experience with the individuals involved and regardless of your

belief about their honesty and integrity. Professional skepticism further requires an

ongoing questioning of whether the information and evidence obtained suggests that a

fraud has occurred. In exercising professional skepticism while gathering and evaluating

evidence, you cannot rely on your belief that the individual is honest, and should not be

satisfied with less-than-persuasive evidence.

PRACTICAL EXAMPLE: Assume you are processing a purchase order

presented by a department head for the purchase of normal office

supplies from an out-of-state vendor. You are curious as to why relatively

normal supplies are being purchased from an out-of-state vendor when a

local vendor can provide the same supplies. Upon inquiry, the

department head states that the out-of-state vendor was selected

because they provided a lower quote, even considering shipping costs.

The application of professional skepticism demands both an unbiased

questioning of the motives behind this purchase and a critical assessment

of persuasive evidence. Merely accepting the department head’s

response to your inquiry does not provide persuasive evidence of the

absence of fraud in regards to this purchase. This purchase order could

be evidence of the department head arranging payment to a fictitious

company for goods that will not be received, or be evidence of a

purchase where the department head may be receiving a kickback.

Therefore, you should not be satisfied with the department head’s

response and should obtain further evidence of the appropriateness of

this purchase by checking out the valid existence of the vendor, the

reasonableness of the prices for the supplies, and the ultimate delivery of

the goods ordered.

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To apply professional skepticism, you must (1) understand the normal purchasing and

spending process, requirements and limitations, (2) being alert to exceptions from the

normal process, and (3) take a proactive approach to investigating and reporting

indications of wrongful spending, rather than merely looking the other way.

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CHAPTER 4 - REPORTING INDICATIONS OF WRONGFUL SPENDING

Exercising Moral Conviction and Courage

It is one thing to possess a proper set of values and know the difference between right

and wrong; it is another thing to actually exercise the moral conviction and courage to

“do what is right” and report indications of wrongful spending. Moral courage can be

described as responding to ethical dilemmas with bravery and courage in the face of

mental and physical challenges or danger that could harm us (e.g. harm our family, job,

self-esteem, reputation, bank account, livelihood, or health). It is the courage to stand

up for the core values of honesty, respect, responsibility, fairness, and compassion in the

face of these dangers. These challenges or dangers may subject you to enormous

pressure; however, when faced with an ethical dilemma involving whether or not to

report indications of wrongful spending or other inappropriate behavior, you must

exercise moral courage and stand up for these core values and focus on your ultimate

responsibilities as a government official or employee to serve the interests of the public

and uphold public trust.

Providing for Effective Lines of Communication

Many employees struggle with the dilemma of whether or not to report potential

wrongdoing. They often find it difficult to balance the perceived conflicting pressures of

“remaining loyal” to the employer versus “blowing the whistle”. A recent study

sponsored by an international accounting firm concludes that one in five American

workers possess personal knowledge of workplace fraud or wrongdoing. However, these

same studies indicate that less than half of these employees report such concerns or

knowledge. Considering these findings, it is essential that the employer provide the

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proper reporting mechanisms and channels of communication and encourage the

reporting of indications of wrongful spending and other unethical behavior. If an

individual is to exercise the moral conviction and courage to report indications of

wrongful spending, the government organization must make it easy for such

communication to occur and with little fear of retaliation or other negative

consequences to the reporting individual. To facilitate these communications, the

government organization and its leadership should consider establishing effective

communication tools such as:

• An Ethics Hot Line

• A Whistleblower Policy

• An Ethics Board or Committee

• An Effective Audit Committee

Establishing an Ethics Hot Line Despite the best efforts of government organizations and their system of internal

control, they are not immune from illegal acts, fraud, abuse, and waste, and will face

challenges in being made aware of such conditions. However, government organizations

can take a proactive approach to this challenge, by promoting an ethical workplace and

providing opportunities for stakeholders (employees, vendors, contractors, citizens,

constituents, and the general public) to get involved and report concerns.

Anonymous ethics hotlines have proven to be one of the most powerful methods for

reporting concerns. Recent studies indicate that organizations without anonymous

hotlines suffer average losses that are twice as high as organizations with established

reporting mechanisms. While some anonymous complaints or reported concerns turn

out to be frivolous and without merit, these studies indicate that the majority of

complaints or concerns received by organizations with ethics hotlines are serious

enough to warrant an investigation. Therefore, collecting the initial report or tip is a

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critical first step to becoming aware of potential illegal acts, fraud, abuse, or waste.

Studies have also shown that people are generally more likely to report complaints or

concerns if they can remain anonymous.

To facilitate the hotline communication, the government organization should provide

simple, straightforward instructions for the hotline process and identify the information

that will be requested. In essence, the government will need the reporting individual to

provide the “who, what, when, where, why, how, and how often” factual information

regarding the complaint or concern. Generally, the following information should be

requested from the reporting individual:

• The nature of the complaint or concern and the circumstances of the incident(s);

• The agency, department, location, and the subject(s) involved;

• Any documentary or testimonial evidence that is available;

• Dates, times, names, and places; and

• The identification of any credible witnesses.

Not all ethics hot lines are effective. For ethics hotlines to work well, they must be

appropriately designed and implemented. The Antifraud Programs and Controls Task

Force of the American Institute of Certified Public Accountants offers the following

advice for establishing an effective ethics hotline:

• Hotlines should have a dedicated phone number, fax number, web site, email

address, and regular mail address to facilitate reporting of complaints or

concerns

• Hotlines should be made available 24 hours a day, seven days a week, and if

possible staffed by a live interviewer (voicemail systems often prove to be

ineffective)

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• Assign a unique identification number to each complaint or concern received to

facilitate continued follow up; a case management log should be maintained to

track all reported incidents and the resolution of the case

• Hotlines should provide for anonymous reporting and protection of the

confidentiality of the informant; consideration should be given to using a third

party (i.e. outsourcing) to receive and process the reported information to

improve the perception of confidentiality

• Hotlines should automatically and immediately route the concern or compliant

information to the appropriate investigators or recipients for follow up; a dual

(two or more people) routing can also be effective in serving as a protective

mechanism to avoid possible conflicts on interest

• Interview processes should be standardized and interviewers should be trained

to gather the information in a clear and complete manner while calming the

fears of the individual reporting the concern

• The hotline communication process should promote continued dialogue

between the interviewer and the reporting individual in order for details to be

clarified and understood

• The existence, purpose, and process of the hotline should be well communicated

through an effective communications campaign, including hotline posters

displayed in prominent places, reinforcement through periodic training,

prominent display on the organization’s web site, and inclusion of reporting

information on pay stubs, customer invoices or bills, newsletters, purchase

orders, checks, and even government vehicles

Establishing a Whistleblower Policy

One of the most common reasons employees do not report observed indications of

inappropriate behavior or wrongdoing in the workplace is because of the fear of

retaliation. To encourage the reporting of complaints or indications of inappropriate

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behavior including indications of wrongful spending, without fear of retaliation, the

government entity should establish a formal whistleblower policy. Such policy should

accomplish the following objectives:

• Provide specific guidance, instructions, and training to employees on what types

of behavior or actions are to be reported, how and to whom the reporting

should be made, and their rights under the whistleblower policy;

• Prohibit interference with the right of an employee to report or blow the whistle,

and provide legal protection for the reporting employee;

• Prohibit retaliation against an employee for having made a complaint or

reported the concern;

• Provide procedures for filing and addressing complaints of retaliation for blowing

the whistle; and

• Provide substantive rewards that encourage constructive whistle blowing.

Whistleblower policies should be crafted within the framework of any federal, state, or

local laws or regulations governing such activities. Such laws and regulations may

include specific procedures for the confidential receipt, retention, and follow up on

complaints or concerns received, and the legal protections for the whistleblower.

Establishing an Ethics Board or Committee While it is important for an organization to have communication channels for reporting

concerns over potential illegal acts, fraud, abuse, and waste, there must also be a

mechanism in place to properly deal with and address these complaints or reported

concerns when received. A formal ethics board or committee can serve such a purpose.

In addition to overseeing the development and implementation of a governments’

formal ethics policy or code of conduct, an ethics board or committee can serve the

following functions in regards to handling ethics complaints or concerns:

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• Provide advice to employees and others on ethical dilemmas and code of

conduct questions or uncertainties

• Serve as the initial point of contact or designate and oversee an individual to be

the contact point for the communication of complaints or concerns

• Conduct or oversee the conduct of investigations into valid complaints and

concerns

• Hear employee complaints regarding alleged retaliation for blowing the whistle

• Make recommendations to management and the governing body regarding what

actions to take in response to investigation results

• Conduct due process hearings in the final resolution of ethics matters

The presence of a formal ethics board or committee can serve as a positive

reinforcement to employees that their complaints or concerns will be handled in a

professional and independent manner.

Establishing an Effective Audit Committee While a government’s governing body is ultimately responsible for the organization’s

accountability and stewardship or resources, an effective audit committee can play a

significant role in promoting a culture of honesty and integrity. The audit committee can

help ensure the government has anti-fraud policies and programs and a strong system

of internal controls in place to prevent, or detect and report illegal acts, fraud, abuse,

and waste. An audit committee should have a broad range of fiduciary responsibility

including:

• Monitoring the entity’s code of conduct and internal control system

• Overseeing the external and internal audit functions

• Instituting and monitoring special investigations

• Reporting audit or investigative findings to the governing body

• Following up on corrective actions

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A properly formed and empowered audit committee is in a unique position to provide

the necessary guidance and oversight of investigations of ethical concerns or complaints

by ensuring that appropriate resources and skills are assigned to gather and evaluate

the necessary evidence associated with the investigation, including resources and skills

of internal or external auditors, appropriate law enforcement agencies, and legal

counsel.

The following are some practical suggestions for establishing an effective government

audit committee:

1. Consider formally establishing the audit committee and its powers and duties by

law or regulation (e.g. constitution, charter, statute, ordinance or resolution).

2. Ensure the qualifications for committee membership provide that the members

of the audit committee collectively possess the technical accounting, auditing,

and financial management expertise needed to understand and address

technical issues.

3. Consider appointing the majority of the audit committee members as qualified

individuals from outside the government, but also include at least one

representative from the governing body or board. The government’s

management should not be represented on the audit committee but may be

present in an advisory role.

4. Ensure audit committee members are provided education and training as to

their role and responsibilities; and that their terms of service last longer than

one year and are staggered to provide continuity.

5. Encourage audit committees to meet as frequently as needed, but at least more

than once a year and maintain minutes of audit committee meetings while being

careful to protect confidential information.

6. Provide for appropriate reporting processes and channels of communication

between the audit committee and governing body.

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CONCLUSION

Government officials are entrusted with public resources and are responsible for

carrying out public functions efficiently, economically, effectively, and ethically, while

achieving desired program objectives and providing public services. An actual

misappropriation of assets from embezzlement or instance of wrongful spending or the

mere perception of such acts through lack of transparency can be the downfall of public

trust. Therefore, it is essential that government officials and employees embrace the

concepts of transparency and accountability for their use of public resources and

promote ethical government spending by (1) establishing the right ethical climate within

the government organization (2) understanding how to define and recognize wrongful

spending, including illegal acts, fraud, abuse, and waste, (3) preventing and detecting

wrongful spending through an effective system of internal control and organizational

fraud awareness, and (4) effectively reporting and communicating indications of

wrongful spending.