US Senate Committee finds DHS Acting Inspector General Lacked Independence

The following story is one I’ve heard from other government auditors over many years. Senior staff without the knowledge or skill to do audit related work creating a negative environment that results in watered-down audit reports.

When I encourage staff to speak out, the common refrain is, “I can’t afford to lose my job.” – which is understandable.

It is good to see, in the following instance, that some brave staff did stand up, testified before the US Senate, to bring about change in the senior ranks of an important agency.

LACK OF INDEPENDENCE

The United States Senate Committee on Homeland Security and Governmental Affairs found that Mr. Charles Edwards, the Acting Inspector General of the Department of Homeland Security, jeopardized the independence of that Office. The Committee found, "Mr. Edwards did not understand the importance of independence. [He] communicated frequently with DHS senior officials and considered them personal friends. Mr. Edwards did not obtain independent legal advice. [He] directed reports to be altered or delayed to accommodate senior DHS officials. Mr. Edwards did not recuse himself from some audits and inspections that had a conflict of interest related to his wife’s employment, resulting in those reports being tainted."

What a damning indictment. Based on this report, Mr. Edwards resigned from his position at the OIG and requested and received a transfer to the Office of Science and Technology at DHS.

It is inconceivable to me that he continues to work at the same agency especially after the Committee found, “…that Mr. Edwards asked and received assistance from an employee who worked on his Ph.D. dissertation.”

In addition, “…the Subcommittee did find that there was a widespread belief that Mr. Edwards engaged in those actions and that belief contributed to an office environment characterized by low morale, fear, and general dissatisfaction with Mr. Edwards’ leadership.”

Here are some of the findings from the Senate Committee report.

Lack of Familiarity with OIG Work

Unlike most IGs, Mr. Edwards does not have experience conducting audits, investigations, or inspections, the three main types of work conducted in an Office of Inspector General. For example, when interviewed by Subcommittee staff, Edwards was unable to articulate guidelines that govern briefing details of an ongoing investigation to DHS. Edwards stated, “I don’t know that offhand here.”

Frequent Communications and Personal Relationships with Senior DHS Officials

Mr. Edwards frequently communicated with both the DHS Chief of Staff and the DHS Acting Counsel. In many of these e-mails, Mr. Edwards offered updates on investigations and audits. Mr. Edwards did not include senior members of his staff on many of these emails and they were not aware of these communications. One senior OIG official called the exclusion of involved staff in these e-mail chains “concerning.”

Edwards socialized with senior DHS officials outside of work over drinks and dinner. 

The Subcommittee obtained e-mails where Mr. Edwards told the DHS Chief of Staff that he truly valued his friendship and that his “support, guidance and friendship has helped me be successful this year”. The Subcommittee also obtained an e-mail to the DHS Acting Counsel where Mr. Edwards wrote “Your friendship, support and advice means so much to me. There are many blessings to be thankful for this year, but one of the best is having a friend like you.”

Lack of Independent Legal Advice

By law, an IG can only obtain legal advice from his own or another IG’s counsel. This restriction recognizes that legal advice from an agency’s General Counsel compromises the independence of the OIG.

The Counsel to the IG stated he was “cut out of some of the major decision-making.” He also informed the Subcommittee that he was not given access to Mr. Edwards’ calendar and his direct reporting relationship with Mr. Edwards ended.

Four former OIG officials told the Subcommittee that Mr. Edwards would go to the DHS Office of General Counsel for advice. The Subcommittee also reviewed an e-mail from Mr. Edwards to the DHS Acting Counsel which appears to contain a request for legal assistance, stating: “I really need some legal help….Please help me for the next four months.”

Improper Alteration or Delay of Reports

There are numerous reports discussed in this section, I would encourage the reader of this blog to read the Committee full report to see what occurred, but here is one part, “OIG officials told the Subcommittee that Mr. Edwards did not consult with his Assistant IG (AIG) for Audits or the Counsel to the IG prior to making this change. According to the Counsel to the IG, this was “entirely inappropriate.” Moreover, the changes were made after the final draft was given to DHS, which was “inappropriate,” and “irregular.”

Tainted Audit Reports

The Subcommittee received allegations that OIG audit reports were tainted due to a conflict of interest presented by the employment of Mr. Edwards’ wife in the Program Accountability and Risk Management office of DHS.

Because of the appearance of a conflict of interest, the OIG had to temporarily remove four audit and two inspection reports from its website and amend them to include a modified independence statement.

ABUSE OF AGENCY RESOURCES

Assistance with Pursuit of a Ph.D.

The Subcommittee determined that Mr. Edwards abused agency resources by asking a staff member to work on his Ph.D. dissertation.

Mr. Edwards’ Acting Chief of Staff provided assistance to Mr. Edwards with his dissertation over a period of at least eight months, from September 2011 to April 2012. During this period, the Acting Chief of Staff said she worked on the dissertation at work and at home, both during and after business hours. This work included research, editing, and proofreading. In total, the Acting Chief of Staff estimated that she spent approximately 20-25 hours assisting Mr. Edwards with his dissertation. The Subcommittee was unable to verify the accuracy of this estimate. The Acting Chief of Staff was allowed to telework while working on Mr. Edwards’ dissertation. Mr. Edwards also appeared to offer to delegate the Acting Chief of Staff’s official duties to other OIG employees to allow her to focus on his dissertation.

Assistance with Employment at Capitol College

The Subcommittee identified at least 15 occasions between September 2011 and March 2012 in which Mr. Edwards asked for or received assistance from a member of the OIG’s technology staff. On one occasion, Mr. Edwards sent the employee a 96 slide PowerPoint presentation and asked her to “do the notes for each slide.” The employee also assisted Mr. Edwards in drafting guidance documents for student assignments and on substantive matters for class tests. This assistance was provided during both official and non-official hours.

Office Environment

During the Subcommittee’s investigation, current and former OIG employees repeatedly reported that Mr. Edwards had created a hostile work environment. One official characterized the office as a “toxic, totally dysfunctional and oppressive” work environment characterized by low morale, paranoia, and fear. Another official described the atmosphere of the OIG as one of “[c]omplete terror,” such that “there were times that [they] couldn’t even get up out of bed, [they were] so emotionally scared, drained.”

Many employees told the Subcommittee they wanted a change in leadership. According to one official, the OIG staff “want to have a legitimate Inspector General in place to get us back on track.” Another called the office “the worst agency” and said that it has been “run into the ground” under Mr. Edwards’ leadership. Reasons include Mr. Edwards’ reluctance to “seek out advice or guidance from anybody with experience” and that the “people … he surrounds himself with … do not have the background or the experience to be useful to him.”

According to one OIG employee, more experienced senior officials refrained from criticizing Mr. Edwards out of fear of repercussions. The Subcommittee was told that “[Mr. Edwards] has a very limited idea of loyalty and people whom he can trust, and if you ever disagree with him, he no longer trusts you.”190 The result, according to multiple OIG officials, has been a steady exodus of agency staff. 191 One OIG official told the Subcommittee that Mr. Edwards’ management style was “my way or the highway, and if you don’t like it, I will either put you on admin[istrative] leave or I’ll make sure that you leave.”

Conclusion

The US Senate Committee’s report was the result of allegations coming from whistle blowers. I hear of similar allegations in other agencies and I always tell staff to think through a strategy that can result in change. I encourage all government auditors to read this report and to see what is possible.

http://www.hsgac.senate.gov/download/staff-report-from-chairman-mccaskill-and-ranking-member-johnson-to-cigie-regarding-investigation-into-the-former-acting-dhs-ig

Problem Audits are Worldwide

"Problem audits" aren't just a U.S. problem.

Big accounting firms are producing deficient audits around the world, according to a new survey of 30 countries' audit regulators—mirroring the experience in the U.S., where regulators have found deficiencies in more than a third of audits by major accounting firms that they have inspected in recent years.

This is from the Wall Street Journal's April 10, 2014 edition: 

http://online.wsj.com/news/articles/SB10001424052702303603904579492440320387248?KEYWORDS=Audit&mg=reno64-wsj

Here is the report:

https://www.ifiar.org/IFIAR/media/Documents/IFIARMembersArea/MemberUpdates/IFIAR-Inspection-Survey-9-April-2014_1.pdf

Livent creditors awarded $85-million due to auditors’ negligence

From the Globe and Mail

An Ontario judge has awarded $85-million in damages to the creditors of long-defunct theatre company Livent Inc., ruling the firm’s auditors at Deloitte & Touche were negligent in their reviews of the company’s 1997 financial statements.

http://www.theglobeandmail.com/report-on-business/livent-creditors-awarded-85-million-due-to-auditors-negligence/article17845004/

Officials Duped Out of $100 Million – Auditors Were No Help at Fletcher Asset Management

Three Louisiana pension funds invested a combined $100 million in 2008 in Fletcher Asset Management. Each of the three funds invested from 3.9 percent to 8.6 percent of their assets in Fletcher's scheme after the firm made a pitch promising to deliver every investor's dream: high returns with low risk.

In fact, the arrangement promised a guaranteed 12 percent return on their money. If the return dipped lower, the difference supposedly would be made up by $50 million put up by a third-party investor.

This week, the Trustee in Fletcher’s bankruptcy said the value of the assets in Fletcher were worth less than $8 million. Fletcher had valued the fund at $352 million.

It’s hard to have sympathy for public pension officials who are gullible enough to fall for a high guaranteed rate of return. The Municipal Employees' Retirement System of Louisiana actually had no policy on credit risk or interest rate risk – fundamental risks that should have been assessed before investing.

Despite this naïve approach to managing public funds, the pension officials should have been able to depend on the auditors to ferret out any wrong-doing on the part of Fletcher Asset Management. Unfortunately, the auditor team failed again to properly carry out its audit responsibilities and as such, failed to alert the public to the significant short-comings in Fletcher’s financial statements.

Based on the Trustee’s investigation, investors were victims of a fraud defined by:

• the extensive use of wildly inflated valuations, 
• the existence of fictitious assets under management, 
• the improper payment of excessive fees, 
• the misuse of investor money, 
• and efforts wrongly to deny the Louisiana Pension Funds a key benefit of their investment agreement – mandatory redemption of their investment under certain circumstances.

The Funds were also victims of an environment where self-interest all too often trumped fiduciary obligations.[1]

The Trustee went on to say,

“Auditors, too, failed to exercise adequate professional skepticism when reviewing valuations; failed to insist on adequate disclosure of related party transactions involving [Alphonse Fletcher] and his family, Citco, and Unternaehrer; and failed to require disclosure of redemption obligations which would have caused a collapse of the Funds.”[2]

There were numerous red flags that ought to have been readily apparent to the administrators and auditors for the Funds. These red flags included: 

• Manager-controlled pricing of customized investments, supported by a valuation agent lacking adequate experience and independence; 

• Massive subscriptions into the Funds in November and December 2008 (following the collapse of Lehman Brothers) from the FAM-controlled Richcourt Funds, when both the administrator and auditor knew that the Richcourt Funds had suspended net asset values (“NAVs”) and redemptions and imposed gating on investors; 

• Repeated massive sudden gains in multiple investment positions; 

• Multiple transactions in major positions at values that were inconsistent with the mark-to-model valuations; 

• Valuation reports that did not meet minimum industry standards; 

• Guaranteed minimum investor returns for certain investors; 

• Absence of any down months over 127 months from June 1997 through December 2007; 

• Fund complexity; 

• Lack of timely issuance of annual audited financial statements; 

• Lack of timely reporting and communications to investors, including delays in receiving monthly and weekly financial data from the investment manager in order to calculate NAVs; Backdating corporate and transaction documents; 

• Ascribing value to non-exercised contract rights to buy securities without actually investing in them; 

• Mismatch between the terms of the investment vehicle and the underlying investments; and 

• Continued inflows and outflow over short time periods from affiliates and related entities.

These red flags should have caused the administrators and auditors to have investigated, disclosed and stopped. None did.[3]

The Trustee identified a number of auditing standards that were not complied with by the auditors. The Trustee said,

“To arrive at their opinions and discharge their duties, Grant Thornton and Eisner were required to plan and perform their audits in accordance with generally accepted auditing standards (GAAS). These standards prescribe the minimum threshold conduct for an auditor. The Trustee reviewed, among other evidence, the accountants’ work papers and deposition testimony, and concluded that the audits performed failed to comply with GAAS. Grant Thornton and Eisner failed to qualify their audit opinions appropriately to acknowledge that the financial statements were materially misstated and should not have been relied on by those receiving them. In this regard, it is important to remember that the audience for these audits was not only the Funds, but also the investors to whom the various audits were addressed.

Grant Thornton or Eisner (or both) violated the following GAAS:

• General Standard No. 1, which requires the auditor to “have adequate technical training and proficiency to perform the audit.”

• General Standard No. 2, which requires the auditor to “maintain independence in mental attitude in all matters relating to the audit.”

• General Standard No. 3, which requires the auditor to “exercise due professional care in the performance of the audit and the preparation of the report.”  Due professional care requires the auditor to exercise professional skepticism. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence.

• Standard of Field Work No. 3, which requires the auditor to “obtain appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements.”

• Standard of Reporting No. 1, which requires the auditor to state whether the “financial statements are presented in conformity with generally accepted accounting principles (GAAP).”

• Standards of Reporting No. 3, which requires that “when the auditor determines that the informative disclosures are inadequate, the auditor must state so in the auditor’s report.”

I’ll examine these in more detail in future blogs.

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[1] Page 4, Trustee’s Report and Disclosure Statement, Fletcher International, LTD., Issued 11/25/13, Case No. 12-12796 (REG). US Bankruptcy Court Southern District of New York

[2] Ibid. Page 8

[3] Ibid. Page 10

NY Times: Accounting World, Still Resisting Sunlight

Here is an interesting article in the New York Times. 

Floyd Norris reports, "The accounting business has sometimes had an attitude of — how shall I put it? — contempt for those who would regulate it. The people who run the major firms know best, and regulators should yield to their superior judgment."

http://nyti.ms/1d3hQrO

Forged Documents – Get Two Out of Prison - Were Risks Assessed?

Two Florida inmates walked out of prison based on forged documents authorizing their early release from life sentences. This is an impressive prison escape and it shows the importance of an appropriate internal control system.

In a letter addressed to Florida's Circuit Court judges, Michael Crews, secretary of the Department of Corrections, writes the department would require verification of any future order from a sentencing judge that results in early release of an inmate.

The inmate will not be released until verification is received, Crews writes. "In light of the potential for fraudulent use of court papers, we believe that the additional step of providing verification of sentence modification court orders is an important safeguard in ensuring the integrity of the judicial process…"

The letter follows after the convicted murderers, Joseph Jenkins 

and Charles Walker

checked in as required by Florida law with a jail after they gained their freedom from the Franklin Correctional Institution in Carrabelle, Florida.

As I've written in previous blogs, forged documents are easy to produce. Clever individuals who understand the systems in place, and where weaknesses exist, can exploit that system.

While there will be legislative hearings on this case, based on my experience, it is likely the Department of Corrections did not formally assess the risk of this type of escape and design control systems to assure the risk was mitigated.

Here is one the forged document related to Joseph Jenkins release:

Auditors Settle Lawsuit in Dixon Illinois Fraud

The city of Dixon, Illinois announced on September 25, 2013 it would receive a $40 million settlement from CliftonLarsonAllen, Fifth Third Bank, and Janis Card and Associates for the fraud Rita Crundwell committed and was not detected by the CPA firms or the bank.

The city sued the CPA firms and bank after its Comptroller, Rita Crundwell, stole $53 million over 20 years. Bruce Devon of the Chicago firm Powers, Rogers & Smith developed a case that clearly showed the shortcomings in the audit process that allowed the fraud to go undetected until Ms. Crundwell took extended leave. At that time, another city employee discovered the bank account Ms. Crundwell used to steal from the city.

Of the $40 million settlement, $35.15 million was paid by Clifton, $3.85 million by Fifth Third Bank, and $1 million by Janis Card and Associates. In addition, federal marshals and the US Attorney's Office recovered about $10 million from the sale of assets owned by Ms. Crundwell who is serving 19 years, seven months in prison.

CliftonLarsonAllen LLP is one of the nation’s top 10 certified public accounting firms. Its CEO Gordon Viere said:

"The allegations of fraud committed by City of Dixon Comptroller Rita Crundwell, some of which she pled guilty to, are extremely serious and present an opportunity for all affected parties to evaluate how they occurred. We believe there was a shared responsibility that resulted in Ms. Crundwell’s fraud continuing undetected, and the right thing to do is reduce the harm experienced by the taxpayers of Dixon and put this matter behind us. Reaching a fair settlement for taxpayers is important to CliftonLarsonAllen."

First - they are not allegations. They are real. $53 million was stolen and Ms. Crundwell went to prison. Second, trying to say there was a shared responsibility that resulted in the fraud going undetected tries to minimize the CPA firm’s responsibility to detect the fraud that occurred. The auditing profession has got to get its act together and begin to find the significant frauds that have brought down major corporations and caused huge losses to government entities.

This was a simple fraud and could have been detected early on if the auditors had simply examined the endorsements on cancelled checks or tried to visit the non-existent capital construction projects that were part of the fraud.

These are basic audit steps and the audit manager admitted they were not done.

This is another black eye for the auditing profession. A profession that is important to the public. It’s time for all auditors to start studying the past frauds that occurred and find the future frauds that will happen.

http://davehancox.blogspot.com/2013/06/incredibly-auditors-miss-53-million.html

http://davehancox.blogspot.com/2013/06/auditors-miss-phony-invoices-would-you.html

http://davehancox.blogspot.com/2013/07/auditor-independence-and-competence-on.html

http://davehancox.blogspot.com/2013/08/send-these-auditors-back-to-school.html

http://davehancox.blogspot.com/2013/08/dixon-auditors-didnt-pay-attention-to.html

http://davehancox.blogspot.com/2013/09/auditors-settle-lawsuit-in-dixon.html

Dixon Auditors Didn’t Pay Attention to History or Professional Guidance

Please refer to : Send These Auditors Back to School

NOTE: The information in this blog comes from indictments and depositions in the civil trial of the auditors for Dixon Illinois. The case is currently on trial. The final verdict will determine the guilt or innocence of the defendants. I’ve taken factual statements from these documents.
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One of my concerns with the auditing profession (which I’ve been a part of for more than 39 years) is, “Do we pay attention to the past? Do we pay attention to why prior frauds occurred, what was the cause of the frauds, and why did the auditors not detect it?”

Many of the past frauds I’ve studied identified similar mistakes made by the auditors in the Dixon fraud. Too bad the Dixon auditors also didn’t study the past.

Another source of information to aid auditors in areas that need attention is the inspection reports now issued by the Public Company Accounting Oversight Board (PCAOB).

In February 2013, the PCAOB issued Release No. 2013-001, its Report On 2007-2010 Inspections Of Domestic Firms That Audit 100 Or Fewer Public Companies.

Some of the areas the PCAOB identified are applicable to the Dixon fraud. These include:

• A lack of technical competence in a particular audit area;
• A lack of due professional care, including professional skepticism;
• Insufficient testing of the completeness and accuracy of source documents;
• Ineffective or insufficient supervision,
• Ineffective engagement quality reviews.

The report authors go on to say:

“The consideration of the risk of material misstatement due to fraud is an integral part of the audit under PCAOB standards. PCAOB standards require that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud….

“Inspections staff have identified deficiencies relating to firms' consideration of fraud in a financial statement audit that include firms' failures to: (a) sufficiently test journal entries and other adjustments for evidence of possible material misstatement due to fraud, including assessing the completeness of the listing of journal entries and other adjustments that is [sic] used for testing purposes; (b) consider the risk of material misstatement due to fraud relating to revenue recognition or indicate why revenue recognition would not be considered a fraud risk; (c) make inquiries of the audit committee, management, and others as to their views about the risk of fraud; (d) conduct a brainstorming session by members of the engagement team to discuss fraud risks, (e) obtain an understanding of the issuer's controls over journal entries and other adjustments, and (f) assess the risk of management override of controls.

“Firms should design and perform audit procedures that address the fraud risks, including reassessing risk and adjusting procedures as appropriate during the audit. The auditor should exercise professional skepticism, and conduct the audit engagement with a mindset that recognizes the possibility that a material misstatement due to fraud could be present”

Unfortunately, in the Dixon fraud we had a partner who claims he didn’t know about the concept of professional skepticism.

They also had an audit manager who didn’t think examining a check could help tell if fraud had occurred.

 

Again, these statements are made under oath and are in a pending court case. It’s just one more piece of evidence that the auditing profession has a long ways to go to ensure it is providing appropriate accountability to the people who are depending on the audit work done.

http://davehancox.blogspot.com/2013/06/incredibly-auditors-miss-53-million.html

http://davehancox.blogspot.com/2013/06/auditors-miss-phony-invoices-would-you.html

http://davehancox.blogspot.com/2013/07/auditor-independence-and-competence-on.html

http://davehancox.blogspot.com/2013/08/send-these-auditors-back-to-school.html

http://davehancox.blogspot.com/2013/08/dixon-auditors-didnt-pay-attention-to.html

http://davehancox.blogspot.com/2013/09/auditors-settle-lawsuit-in-dixon.html