Internal control failures at the Pine Grove YMCA.

Elson, Raymond J. ; O'Callaghan, Susanne ; Holland, Phyllis 等

CASE DESCRIPTION

The primary subject matter of this case concerns internal control failures in a nonprofit organization which resulted in two overlapping but unrelated fraud. The case has a difficulty level of four, appropriate for senior level. The case is designed to be taught in one class period and is expected to require five hours of outside preparation by students. This case can be used in an internal or external auditing class, a fraud course, or a nonprofit accounting class.

CASE SYNOPSIS

The case relates to accounting control failures in a nonprofit organization which resulted in two unrelated fraud. It is loosely based on a real world situation and so, the organization's name and the fraudsters' identities are disguised.

The first fraud involved the accounting manager, who stopped paying both state and federal payroll taxes on behalf of approximately 150 YMCA employees. She continued to file false quarterly payroll tax returns for a number of years, retaining the money in the organization's operating account. These actions resulted in the organization incurring a tax liability of approximately $1.4 million. In addition, the accounting manager wrote more than 168 checks for approximately $40,000 to herself from the organization's bank account over a five year period, disguising most as payroll checks. She also used her purchasing card to acquire approximately $23,000 worth of personal merchandise.

The second fraud involved the executive director, who hired a local contractor to perform landscaping and renovations at the YMCA locations. The contractor was also hired to perform renovations on the executive director's personal residence. As part of the 'contractual relationship', approximately 26 of the contractor's employees were placed on the YMCA's payroll with the executive director's approval. In addition, materials and equipment brought with the organization's funds were used for landscaping projects at the executive director's residence with the contractor's employees performing the work. Approximately $377,000 of the organization's funds was diverted to the landscaper's employees with an additional $487,000 paid to the contractor for construction and repairs services.

The executive director converted approximately $850,000 in federal YMCA funds for his use, disguising them as payments from the YMCA to the contactor. He then concealed his actions by destroying the records. The executive director also converted approximately $58,000 of the organization's funds for personal purposes.

INTRODUCTION

"I can't believe this is happening to me," thought the accounting clerk as she slumped into her chair. The executive director had just informed her of the accounting manager's emergency two-week vacation. On one hand, her dream of having more responsibility had finally come true, but on the other hand it was the beginning of the month. There was so much to do--close the books, reconcile the general ledger accounts including the bank accounts, and prepare monthly financial statements--in addition to her normal duties. Clearly, she would need to prioritize her tasks and try to accomplish as much as possible while waiting for temporary help or the accounting manager's return.

The accounting clerk thought that reconciling the bank accounts was a logical starting point. Pine Grove YMCA only had two bank accounts, the operating and payroll accounts, and the accounting manager never complained about reconciling them. In fact, reconciling the bank accounts was the accounting manager's first priority each month. The accounting clerk found the unopened BB&K bank statements with the bank reconciliation file (containing the previous bank reconciliations) on top of the accounting manager's desk. The only missing item was the cash balance from the general ledger and so she printed the cash summary from the system. She was now ready to proceed with the easiest task of the day.

The accounting clerk compared the cash balance for the operating account on the bank statement to that on the general ledger and could not believe her eyes. The general ledger balance was significantly higher than the bank balance. Alarmed, she tried to identify reconciling items such as deposits recorded in the general ledger but not in the bank and outstanding checks but found only outstanding checks. She recorded these on the bank reconciliation but this only increased the difference. Still puzzled, she looked at the previous month's bank reconciliation for any reconciling items or unusual activities. The only reconciling items were outstanding checks which cleared the bank as noted on the current bank statement.

However one item caught her attention, the previous month's ending bank balance on the bank reconciliation should be the same as the beginning balance on the current month's bank statement, but it was not. The general ledger balance is correct, she thought, so the bank made a mistake within their system and sent a statement with the wrong beginning balance.

The accounting clerk called her account manager at the local BB&K branch, explained the problem and requested a corrected bank statement. The account manager promised her that he would investigate the matter and contact her before the end of the day regarding its resolution. Assured that the matter would be resolved, the accounting clerk thanked him, concluded the phone call, and placed the reconciliation in her pending file.

In the interim, the account manager contacted his branch manager to inform him of the recent conversation with the YMCA's accounting clerk. The BB&K branch manager placed a call to the YMCA's executive director to discuss the conversation that took place between the accounting clerk and the account manager regarding the discrepancy in the YMCA's bank account.

This conversation triggered what would later be considered one of the unfortunate events in Pine Grove, Michigan. Soon everyone--from the accounting clerk to the local newspaper editor--would be talking about the funds that were stolen from the YMCA.

No one could understand how such respected members of the community, the executive director of the "Y" and the accounting manager, could breach their fiduciary duties by stealing from such an important institution in the community. An angry community wanted to know how two individuals could steal over $2.5m from the institution over a five year period without detection.

There were so many unanswered questions: "Was there no supervision?", "How could the Independent accountant not be aware of this fraud"? "What were the board members doing over the last five years?" "How many employees at the YMCA knew about the fraud, and did nothing?"

BRIEF HISTORY OF THE YMCA

The Young Men's Christian Association (YMCA or the Y) was founded approximately 166 years ago in London, England, in response to unhealthy social conditions arising in the big cities at the end of the Industrial Revolution. The YMCA came in North America in 1851 and was first established in Montreal, Canada on November 25th and in Boston, Mass on December 29th. Today, YMCAs serve thousands of U.S. communities assisting approximately 21 million children and adults of all ages, races, faiths, backgrounds, abilities and income levels. The mission of the YMCA is putting "Christian principles into practice, through programs that build healthy spirit, mind and body for all."

In 1967, the community leaders of Pine Grove, Michigan came together with a common goal--to bring a YMCA affiliate to their town that would emulate the "Y" mission of developing character by teaching and demonstrating positive values.

THE PINE GROVE YMCA

Organizational Structure

The Pine Grove Y grew so that by 2000 Tom Richards became the executive director and chief executive officer reporting to a 12-member board of directors. The board of directors, like most nonprofit boards, was a volunteer board and its membership consisted of prominent community leaders. These leaders were invited to serve on the board by the executive director. Board members served for an initial three-year term, and could be elected for a second term. Terms were staggered so that 1/3 of the board members were elected each year. The board did not have separate committees due to its size, but it had four elected officers who served one-year renewable terms. The officers at the time of this incident in 2008 consisted of the President (who was an attorney); a Vice President (a retired banker); a Treasurer (a CPA); and a secretary (a retired real estate developer).

The executive director was supported by an assistant director, Tina Benson who ran the day to day activities of the YMCA. All programs directors reported directly to Ms. Benson. However, supporting services such as maintenance and accounting all reported to the executive director.

The organizational structure is illustrated below:

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The executive director was the driving force behind the Pine Grove YMCA, and its budget, membership and programs, all grew under his 10 year leadership. Among his various accomplishments were opening of a satellite YMCA location in a neighboring town, opening of a gymnastics center, creating a Big Brothers/Big Sisters program, and opening a day care facility.

Funding Sources

The organization relied on membership dues for a significant portion of its budgeted income, with memberships available on an individual or family basis. Pine Grove created a number of flexible options in order to attract more members. For instance, it offered discount memberships to employees of the largest employers in Pine Grove and the surrounding county. Members could pay their dues via payroll deductions, cash, credit cards and bank drafts. Members could also make payments on a monthly, quarterly, semi-annual or annual basis. Limited scholarships were also available for prospective members who were able to demonstrate financial hardship.

Other income sources include donations from the United Way, summer camps, day care, and the annual golf tournament. As noted earlier, the organization's budget increased under the executive director's leadership from approximately $100,000 annually when he arrived in 1998 to the current $8 million in 2008.

The Accounting Department

The accounting department consisted of two accounting personnel, the accounting manager (Sue Jackson) and the accounting clerk (Tiffany Overlook). Ms. Jackson, an eight year YMCA veteran, was the main bookkeeper and served as a 'quasi-department head' since the organization did not have a controller position. Ms. Jackson was responsible for the cash receipts and disbursement functions which included depositing funds in the bank, preparing and processing all cash disbursements, preparing monthly bank reconciliations of the two bank accounts, and preparing monthly financial reports. She also served as the payroll clerk and this role included remitting taxes withheld from employees' paychecks to the various taxing jurisdictions and filing the related payroll tax returns.

The YMCA began using purchasing cards (i.e., YMCA credit cards) for daily purchases, and Ms. Jackson was responsible for this function. However, the executive director and accounting manager were the only YMCA employees provided with these purchasing cards. Ms. Overlook worked at the YMCA for approximately one year and served as the accounts receivable clerk. She was primarily responsible for updating members' accounts to reflect payments received as well as sending reminder notices to members regarding upcoming and delinquent payments.

The board of directors' treasurer reviewed the monthly financial reports and the executive director generally met with the board monthly to discuss financial and other YMCA matters. The accounting manager did not attend board meetings or interact with the board members. The YMCA also employed a local accounting firm to review its financial statements on a quarterly basis.

THE ETHICAL FAILURE AND FRAUD

Two unrelated but overlapping ethical breakdowns occurred at the YMCA during the five year period, 2003-2007. The first involved the accounting manager, Ms. Jackson, who stopped paying both state and federal payroll taxes in 2006 on behalf of approximately 150 YMCA employees. She continued to file false quarterly payroll tax returns for a number of years, retaining the money in the organization's operating account. These actions resulted in the organization incurring a tax liability of approximately $1.4 million over the course of five years. In addition, Ms. Jackson wrote more than 168 checks for approximately $40,000 to herself from the organization's bank account for the five year period 2003-2007, disguising most as paychecks. She also used her purchasing card to acquire approximately $23,000 worth of personal merchandise from a local store during the same time period. These personal items included school supplies for her two elementary age daughters, a new flat screen television for her family room, and food.

The accounting manager developed an elaborate scheme to cover up her wrongdoings. Using her work computer, she created fraudulent bank statements which she sent to the independent accountant in lieu of the original statements received from the bank.

The second incident involved the executive director, Mr. Richards. He hired a local contractor, Tim Jones, to perform landscaping and renovations at the YMCA locations. The contractor was also hired to perform renovations such as building an addition and a screened in porch, on the executive director's personal residence. The contractor was hired based on personal relationships, without a competitive bidding process, or board of directors' approval. The executive director and the contractor attended the same church, at which the contractor was both a deacon and Sunday school teacher.

As part of the 'contractual relationship', approximately 26 of the contractor's employees were placed on the YMCA's payroll with the executive director's approval. In addition, materials and equipment brought with the organization's funds were used for landscaping projects at the executive director's residence with the contractor's employees performing the work. These employees were paid by the YMCA for landscaping projects performed for other clients of the contractor. The contractor was also paid with the organization's funds for ongoing landscaping work at the executive director's residence. Approximately $377,000 of the organization's funds were diverted to the landscaper's employees with an additional $487,000 paid to Mr. Jones for construction and repairs services.

The executive director converted approximately $850,000 in federal YMCA funds for his use, disguising them as payments from the YMCA to the contactor. He then concealed his actions by destroying the records. These funds were the accumulated payroll taxes retained in the organization's bank account by the accounting manager as noted above. The executive director also converted approximately $58,000 of the organization's funds for personal purposes using his company issued purchasing card. Items purchased included suits, shoes and toiletries.

THE FRAUD UNRAVELS

Upon concluding the phone call with the bank, the executive director contacted the chairman of the board and the treasurer to inform them of the discrepancy in the YMCA's bank balance. An emergency board meeting was initiated by the chairman and the treasurer was authorized to investigate the issue on behalf of the board. The treasurer contacted a local accountant, Ms. Ellen Graves, who was also an accounting instructor at Pine Grove Junior College and asked her to investigate the matter. Ms. Graves was a CPA with five years of public accounting experience in a regional accounting firm. The treasurer also notified the executive director of the investigation and asked for his full cooperation. The executive director agreed to provide the accountant with an office on the organization's premises and pledged his cooperation with the investigation.

Ms. Graves' first action was to review the bank reconciliation of the organization's bank balance in order to understand the extent of the problem. Her first step was to review the accounting clerk's bank reconciliation to ensure its validity. Since she had access to the bank reconciliation file, she also reviewed previous months' bank reconciliations including the supporting documents such as bank statements. She could not believe what she saw--the current month's bank statement showed that the YMCA had only approximately $3,000 as compared to the $25,000 on the accounting manager's bank statement from the previous month. Ms. Graves immediately notified the executive director and the board of the problem. The board chairman and treasurer were furious and demanded that the accounting manager be terminated. The executive director complied with the board's direction and the accounting manager was terminated on April 15, 2008 and the police were contacted. Thus began the formal investigation of the former accounting clerk, Ms. Jackson.

At this point, the board had no confidence in the financial information of the YMCA and asked Ms. Graves to expand her investigation to include all financial activities of the organization for the past three years. Ms. Graves started her review of cash disbursements for the most recent year, 2007. She noted a number of payroll checks that were written from the operating account. This created a red flag since all other payroll checks were written from the separate payroll account. She simply cross referenced the payee names on the checks to YMCA employees listed on the detailed organization chart and concluded that these were ghost employees. Again, Ms. Graves contacted the board and discussed her concerns with the treasurer and chairman. Another emergency meeting was held between Ms. Graves, the treasurer, the chairman, and the executive director. The executive director was clearly relieved that the questions were being asked about the fictitious employees and other matters.

The executive director shared that these employees actually belonged to a local contractor and not the YMCA but the YMCA was paying their salaries. The executive director was terminated by the chairman of the board on May 15, 2008. The assistant director assumed temporary leadership of the organization until the current issues were resolved. The police were again contacted and a formal investigation began on the activities of the executive director. A second and larger accounting firm with more experience with fraud issues and forensics accounting was hired by the board to investigate the extent of the fraud committed by the accounting manager and executive director.

On July 1, 2008, indictments were handed down by the United States District Court of Warren County, Michigan, against the former accounting manager and executive director of the YMCA, and against the landscaper. The accounting manager was charged with embezzlement, mail fraud and mailing fraudulent financial statements. The executive director and landscaper were both charged with conspiracy to commit embezzlement from an organization receiving federal funds. The executive director was also charged with making false statements to FBI agents.

A CALL TO ACTION

Assume that you are the independent accountant hired by the organization when the discrepancies were discovered.

1. Using the fraud triangle below, explain to the board of directors how the fraud was perpetrated without timely detection by organization personnel or the board of directors.

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2. Using the COSO framework as a guide, identify the control concerns (or weaknesses) you might find in the organization that provided the opportunity for the fraud to take place. Using Appendix A as a guide, write a formal report to the board of directors to discuss these weaknesses and your recommendations to address the control deficiencies.

3. Explain the difference between an ethical failure and a criminal or illegal act to the board of directors.

APPENDIX A--FORMAL REPORT

Date: (date work was completed)

To: The Board of Directors

The Pine Grove YMCA

From: Independent Accountant

Audit Results

This section provides a high level summary of the significant business issue(s) identified from the COSO framework.

Issues and Recommendations

The details of each issue along with the recommended remediation activity are provided in this section. Students should limited themselves to no more than three business issues.

Raymond J Elson, Valdosta State University

Susanne O'Callaghan, Pace University

Phyllis Holland, Valdosta State University

John P. Walker, Queens College/CUNY