Question About Assignment

Public Sector Financial Management Case Study – MPA Capstone

Background: Internal Control Review

When conducting a financial and compliance audit the accountants review the internal controls of the

audited organization. The internal controls are the systems an organization has established to 1) prevent

fraud and waste; 2) ensure accuracy of the accounting and other operating data; 3) promote adherence

to state policies; 4) further the efficiency of operations; and 5) ensure conformity with applicable laws.

Systems devised to achieve the first two objectives are often referred to as accounting controls; the latter

three aims are often referred to as administrative controls. To comply with “generally accepted auditing

standards” or GAAS in a narrow and literal sense, the accountants may concentrate on examining the

accounting controls. But in most audited organizations the accounting and administrative controls

overlap extensively, so the accountant examines the entire body of internal controls.

This internal control review is but one of several steps in arriving at a professional judgment

regarding the “fairness” or reliability of the financial reports of the audited organization. For local

governments, the internal control review can be an end in itself – a source of valuable observations about

the strengths and weaknesses of financial management practices. Many local officials are more

interested in the accountant’s evaluation of internal controls than they are in the accountant’s opinion

about the financial reports. Accountants, in response to this interest, usually prepare a separate,

informal report on internal controls, in which they list the major weaknesses they have found alongside

their recommendations for remedial action. This informal report often is referred to as the “letter to

management” or simply the management letter.

The executives within the audit organization may have extremely contrasting points of view

about the management letter. As is often the case, the letter may dwell upon technical and narrowly

defined problems, which may be important to a few middle and lower level managers but of no practical

relevance to the rest of the bureaucracy. However, sometimes the accountant may include in the

management letter observations about major system problems. There is a high probability this will

happen if the accountants are performing their first audit of the community and if a number of major

system problems in fact exist. In these cases the accountants usually prefer to put their observations on

record. Executives generally aligned with the status quo may view these observations as a threat;

executives who are more willing to promote or accept change may view the observations as a refreshing

breath of fresh air. In any event, the management letter provides an excellent opportunity for a fresh,

objective analysis of the auditee’s management practices and operations.

The case which follows draws upon an actual professional audit of a large American city. It was

the first professional audit of the city’s more than 150-year history. The case is written from the

perspective of a middle-level manager whose job is affected by the contents of the accountants’

management letter.

Case Study: The Evergreen Audit

In late June, 2016, Susan Dewing received a memorandum from

her boss, the budget director of the city of Evergreen. The

memorandum asked Susan to recommend what the director

should do about the management letter, which the city’s

accountants had recently submitted in final form.

Susan joined the city about the time the audit began, that

is, a year ago. Her assignments generally dealt with developing

procedures for improved budgetary analysis and improved

interim-year spending controls. As part of her work, she built up

an introductory knowledge of the accounting system of the city.

The unit she worked in was commonly perceived within City Hall as favoring greater application

of advanced analytic methods in financial management. The Budget Office of the city falls within the

Finance Department. Other units of the Finance Department include Auditing, Purchasing, Systems and

Procedures, and Data Processing.

Susan was aware that the budget director’s management priorities were as follows: 1) Improve

the quality of personnel/payroll data used in annual budgetary analysis, forecasting of employee benefits,

and labor contract negotiations; 2) improve the quality of budgeting of data processing; and 3) impose a

quarterly allotment system to control interim spending.

Moreover, Susan was aware that the mayor, who was deeply engaged in a campaign to be

reelected in a September primary, was unenthusiastic about the audit, so that neither he nor his aides

had shown any interest in the management letter.

She felt that she first had to sort out the short- and long-run implications of the audit and the

management letter for the mayor and the budget director. How might their goals (what she knew and

could infer) be influenced by the management letter? How could they best take advantage of it? She also

had to consider her own position and future within the city. How might the management letter be used

to improve her standing with City Hall?

She sketched out on a pad a crude list of alternative steps that could be taken by the city in

response to the management letter. These steps were not mutually inclusive. The list was for her a

starting point for preparing a report to her boss:

OPTIONS: postpone until after primary

Initiate in-house task forces

Hire consultants or use the accountants to follow up

Think of more

The more she thought about the problem of what to do with the management letter, the more she began

to entertain simultaneously two entirely contradictory questions about the management letter: Was it a

vehicle for management reform or a terrorist bomb?

The audit of the city was for the FY ending June 30, 2015. As is typical in first-time audits of large

government organizations, the audit work extended over a year, starting in early 2015 and ending in the

spring of 2016. They submitted a revised and final version of the management letter in May, 2016. The

city released copies of the management letter to the press in June.

A summary of the management letter, observations about payroll- and vendor-payment

practices, and a brief, incomplete assessment of executive responses to the observations are included

below.

Payroll

Over 70 percent of the expenditures of the city was payroll. In a bewildering variation on form and period

of payment, city employees, the accountants discovered, were paid on one of the four days in the week,

and on a weekly, semiweekly, or monthly basis. The accountants found that current practices had

resulted in delayed payments to new employees, payments to employees who had been terminated,

incomplete processing of federal income tax forms and other deductions, payroll charges to incorrect

budget codes, and unnecessary clerical costs.

In the first steps of the payroll cycle, employees had been hired and the specific information on

their employment was entered in the central payroll register. The accountants found that since there

was no effective integration of the personnel department (the department which had hired the

employee) and the payroll department (the department that paid the employee), there were delays in

putting new employees on the rolls.

Time sheets, while filled out by several thousand workers, were worthless indicators of employee

performance. Many line managers routinely signed payroll authorizations without ascertaining whether

PRESS RELEASE

City Public Affairs Office

Contact: Joel Berman

Hold until 4:00 p.m., June 16, 2016

Mayor Edward Silvers received this morning the official management report of the city’s auditors, McHenry & Co.

At a meeting attended by Mayor Silvers, Robert Crum, partner in McHenry & Co., and Eileen Raymond, the director of finance, Mayor Silvers received a brief presentation of the major findings and recommendations of the auditors.

According to Mr. Crum, the auditors found no major problems in the financial administration of the city, and they were impressed by the dedication and talents of city employees.

Mayor Silvers and the finance director expressed their appreciation of the professionalism of the auditing team headed by Mr. Crum.

The finance director will review the management report with city personnel and will report back to the mayor within two weeks.

employees showed up for work. The payroll department, for its part, did not have a list of authorizing

forms were legitimate.

Once payroll information was prepared by the audit division of the payroll department, the data

were put into the city’s computer to produce paychecks. The city ran an “exception based” payroll system

whereby the payroll master data files on the computer were designed to produce paychecks on schedule

unless there were any exceptions or changes. The payroll audit division did not, as a practice, check the

computer files to determine that only changes authorized by them were made to the files and that all of

their authorized changes were in fact made.

Procedures for distributing checks invited theft or manipulation of the system. According to the

accountants, any employee could pick up checks for his or her department at the Treasury Department

window. Batches of checks were delivered to employees on the street by un-bonded employees. During

the audit, there was a holdup of a city pay check distributor.

These weaknesses in controls over payroll struck some city executives as rather trivial, resulting in

inconvenience to employees and, at worst, a potential loss of a relatively limited amount of funds.

However, the new budget director felt that failure to enforce detailed controls at the mundane level of

daily payroll operations comprised the city’s capacity to manage its financial affairs at higher levels. For

example, the city had a residence requirement for employees. Neither the personnel nor the payroll

department made a serious effort to verify reported residences. Furthermore, there were serious

inadequacies in the personnel data, as evidenced by the return by the Postal Service of one tenth of the

W-2s mailed by the payroll department. Unfortunately for the city, these files were the primary source of

information used to project the future costs of payroll increases and changes in benefits.

Vendor Purchases

Three hundred steps were required to order, receive, and pay for goods from vendors. This maze of

controls resulted in delays, high costs, and poor vendor relations. They did not prevent major scandals

from occurring, for example, in the award of contracts to the departments which managed the city’s

parks and tax-title property. Delays of three to four months in paying bills alone were frequent. The

city’s internal auditor estimated that each purchase order cost the city about $40 to $50 to process.

Many departments failed to maintain inventory records and to order in economical quantities,

the accountants found. In addition, the accountants found that some departments irrationally awarded

contracts to lowest bidders who were almost certain to fail to deliver, while other departments clung to

extremely precise specifications and selected high bidders.

The most serious weakness in vendor purchases was in the inordinate processing delays which

occurred throughout. One cause of delay was chronic confusion over who was responsible for certifying

the availability of funds. Line department managers believed that the budget department, when notified

of a requisition order, checked for availability of funds. Budget Department personnel, however,

contended to the accountants that their job was only to certify that the correct appropriation account

was charged. As it happened, neither line nor budgetary officials were authorized to reserve funds

formally. That was the job of the Auditing Department, which would reject requisition orders (already

weeks or months old) for which funds were not available at the time the Auditing Department matched

the order with the appropriate records.

Vendors were selected through a highly formalized and time consuming competitive bidding

process, supervised by the city’s Purchasing Department. After this department would designate an

awardee, it would prepare a formal letter of award which it would send to the mayor’s office by way of

the city’s legal department. The accountants estimated that it took an average of 25 days after the

preparation of the award letter by the Purchasing Department for the mayor to sign the letter.

The order for the desired goods still could not go out until a formal contract was signed. There

was no uniform contract and weeks would go by as supporting documents and required signatures were

collected and reviewed by the law and auditing departments. Only after their review was complete could

the line agency manager place an order.

These delays, justified on the grounds of statutory requirements, discouraged many vendors from

bidding and drove bid prices up to include implicit financing charges. The delays abused the patience of

the better quality city executives. Some executives had already concluded that procedural difficulties in

vendor purchases contributed to the poor performance record of the city’s data processing department,

since municipal data processing shops typically depend very heavily on outside vendors to provide

equipment, maintenance, and consulting. The problems with vendor purchasing had persisted because

no city department or key official had been sufficiently motivated and influential to streamline controls.

Instructions: Write Ms. Dewing’s memorandum. What recommendations should be made to the budget director?