Editors note: This is a guest post from recent candidate for City of Houston Controller Bill Frazer.
“The tone set by top management—the corporate environment or culture within which financial reporting occurs—is the most important factor contributing to the integrity of the financial reporting process.” – (Report of the National Commission on Fraudulent Financial Reporting, October, 1987, Page 38)
As a result of my good friend Bob Lemer’s efforts for many years, the City of Houston finally released a long list of auditor’s reports. The release of these audit letters has received a lot of press lately, so I thought I’d walk you through the summary findings for the past seven years to illustrate what’s been going on, or not going on, with respect to the City’s systems for accounting and financial reporting.
It’s important to note that there has never been any report or indication of fraudulent reporting. I think when you get through reading this lengthy narrative you’ll agree that we still have some serious problems with the tone at the top, and that the City needs to clean up its accounting, reporting and internal controls.
A good start would be to immediately form an Independent Audit Committee, as highly suggested by the Government Finance Officers Association (the “GFOA”). This should be a top priority of the Mayor’s Office and Council Committee on Budget & Fiscal Affairs.
In its recommendation for audit committees the GFOA specifically states that “The audit committee should be formally established by… appropriate legal means and made directly responsible for the appointment… of any independent accountants…[and] all accountants thus engaged [should] report directly to the audit committee.”
Accounting and audit reports are dry and overly technical, so allow me to draw a simple analogy to help non accountants understand what’s going on.
While on vacation in California several years ago I noticed that they use a grading system for retail food establishments like restaurants, fast food places, bars, etc. The health inspector issues a card with the grade on it, a large bold “A”, “B” or “C: that the restaurant is required to post in plain site near the entrance, for all to see.
Most establishments get an “A”, which means “Generally Superior in food handling practices and overall food facility maintenance.” “B” means “Generally Good” and “C” means “Generally Acceptable.” There are a few B’s and C’s, but frankly I’d be reluctant to try them. Would you dine at a “B” or “C”?
Better still, let’s assume for a moment that you are an investor in a restaurant that got a “C” and you’re not only forced to eat there but have to make capital contributions to keep the place open. Management completely ignores the problem and hides the grade card from you. How would you feel about that?
There is a grading system for the reviews that auditors conduct on the internal controls of companies and government entities such as the City of Houston. If we could put letter grades on the auditing system, the City of Houston would have received a C (Significant Deficiency) in three of the past seven years and a D (Material Weakness) in four.
That’s right! Your tax dollars are supporting an administration that gets Cs and Ds in Internal Controls. Not only do they completely ignore the grades and the problems that cause them, they tried to hide the grade cards from public view.
Accounting and financial reporting systems in companies and municipalities have to meet minimum standards and have processes designed to provide reasonable assurance with regard to the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations. This includes the safeguarding of assets and providing reasonable assurance that someone doesn’t walk off with or embezzle a lot of money.
Auditors test these systems during the financial statement audit and issue reports on their findings typically referred to as “management letters” or “internal control reports”.
It’s important to note at this point that even though the Management Letters were released last week, the exhibits and appendices were not. It remains to be seen if these additional exhibits will shed any more light on the matter.
Although Houston’s auditors have issued Management Letters for quite a number of years, the rules for reporting internal control weaknesses changed in 2006. So I’ll start there and will go through a set of findings over a seven year period. I’ll start with the report issued for the year ended June 30, 2006 and will go through the latest report issued for 2012. I have to stop there because the report for the year ended June 30, 2013 report hasn’t been issued yet. The deadline for the 2013 report is February 10th.
During a financial statement audit the auditors may notice internal control deficiencies. A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct misstatements on a timely basis.
If everything looks OK there are simply no findings reported. If the auditors notice any deficiencies they categorize them into two types. One type is a Material Weakness, a really bad grade, which means there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis.
The other type is called a Significant Deficiency, which is less severe than a Material Weakness, yet important enough to merit attention by “those charged with governance”.
In 2006 the auditors reported a Material Weakness in internal controls over financial reporting. This is at best a grade of D. They reported, in Finding 2006-1 “The City’s financial accounting and reporting process is not adequate to ensure that accounting transactions are being properly captured and recorded by the City in its financial statements.”
The City promised to fix this problem by conducting financial management literacy courses for City department heads and executive staff. After that, these people would review process and procedures to reduce the number of accounting errors. Estimated completion date was December, 2007.
The following year, Finding 2007-1 was issued as a Material Weakness, and stated: “The City’s financial accounting and reporting process is not adequate to ensure that accounting transactions are being properly captured and recorded by the City in its financial statements.”
Sound familiar?
The City promised again to fix this problem by conducting financial management literacy courses for City department heads and executive staff. But the estimated completion date was pushed back to December, 2008.
Moving on to 2008 and Finding 2008-1, a Material Weakness: “The City’s financial accounting and reporting process is not adequate to ensure that accounting transactions are being properly captured and recorded by the City in its financial statements.”
Wow. A trifecta~! The very same Material Weakness three years running.
This time the City promised to fix the problem through “… a process of quarterly reconciliations and financial statement preparation. Instead of waiting for the annual audit, these periodic reviews will improve the proper reporting of financial operations.” Promised completion date: December 2009.
I’m happy to report that the following year, 2009, there were no Material Weaknesses reported, so whatever they started doing seemed to be working. Instead, the issue was downgraded to a Significant Deficiency, reported as 2009-1: “While there was significant improvement in the City’s financial reporting process in the current year, the City should enhance this process by requiring responsible financial reporting personnel, at the department level, to perform analytical reviews of financial results on a periodic basis, and also review and approve material journal entries that affect their respective departmental financial results.”
The City’s response: “Departments will perform quarterly analytical reviews of financial results and review material journal entries.” Estimated completion date: June 2010.
Well, THAT didn’t work out so well. The following year the auditors reported that the issue was not adequately addressed, so they upgraded the issue back to a Material Weakness, as Finding 2010-1: “The City’s financial accounting and reporting process is not adequate to ensure that accounting transactions are being properly captured and recorded by the City in its financial statements.”
The City’s response this time: “City officials intend to form a team consisting of accountants and system personnel from several of the City departments to review the year-end financial accounting and reporting process and to make suggestions for improvements.” Promised completion date: June 2011.
June 2011 rolls around and VOILA~! The Material Weakness has now been demoted once again to a Significant Deficiency in the form of Finding 2011-1: “While there was significant improvement in the City’s financial reporting process in the current year, the City should enhance this process by requiring responsible financial reporting personnel, at the department level, to perform analytical reviews of financial results on a periodic basis, and also review and approve material journal entries that affect their respective departmental financial results.”
Significant Improvement? At least the auditors should be offering a discount for being able to just copy prior years’ findings. This time the City said: “The City will develop a procedure to support high level analytical reviews. A review of the journal entry approval level will also be made.” Estimated completion date: September 30, 2012.
You won’t believe the findings for 2012:
Finding 2012-1. “While there was significant improvement in the City’s financial reporting process in the current year, the City should enhance this process by requiring responsible financial reporting personnel, at the department level, to perform analytical reviews of financial results on a periodic basis, and also review and approve material journal entries that affect their respective departmental financial results.”
The City’s response: “Establish a policy and procedure to determine a financial threshold to trigger an automatic review by respective Departments which will also be monitored by Finance Department. In addition, any unusual transactions will be reviewed by Finance and Controller’s Office as they occur.” Estimated Completion Date — Policy to be completed by March 15, 2013
As one famous restaurant health code reporter used to say: “Slime in the ice machine.”
It’s simply time for the City of Houston to join the rest of the world and appoint an independent audit committee.
Bill Frazer
enlightening.