In this issue, we conclude our series on the financial statement by examining fraud. Corruption is extremely rare; in my experience, most board members, managers, and vendors tend to be honest and just want to do their jobs as best they can. Nonetheless, you must be aware of warning signs.
The Pointless and the Pointed
I have sat through many annual meetings where shareholders cross-examine the auditor about why the building bought more toilet paper or why the cost of operating the building increases. And every year, it is always pointless: boards rarely have control of more than 15% of costs. That’s because the biggest costs – real estate taxes, payroll, debt service, insurance, and fuel – are not within the board’s control. Therefore, instead of badgering the members about areas over which they can do little, owners would be better off guarding against fraud. That’s why the annual audit is so important. The auditor is like a real-life Sherlock Holmes.
Some of the warning signs that you should watch out for include these scenarios:
• The building frequently changes management companies, which prevents the management company from developing an institutional memory of the association and enabling it to ask questions.
• The building frequently changes the auditors, possibly to avoid embarrassing disclosures.
• The building frequently changes the professionals who prepare reserve studies, ostensibly in an attempt to seek lower reserve amounts (and hence lower assessments) but which may be done for more insidious reasons.
• The building frequently changes the professionals who prepare insurable replacement cost valuations in an attempt to seek lower property insurance limits (and hence lower premiums) but which may be done for more insidious reasons
• Building engineers and architects are replaced in what could be an attempt to avoid making costly repairs or reduce replacement costs.
• Board or management establish an unrealistically low budget.
• Management has sole check-signing authority.
• The board or management drops certain insurance coverage, ostensibly to reduce costs but possibly for insidious reasons.
The nature of the industry provides opportunities for fraudulent financial reporting since the management company usually keeps accounting records and does financial management off-site, far removed from the board’s scrutiny. On the other hand, there may be too much togetherness when an association is self-managed with no outside oversight.
Another potential problem arises when the manager has access to multiple bank accounts for many clients and secretly (and illegally) commingles them. Similarly, because a vendor may work for multiple clients within the management company portfolio, payments to a vendor from one client for work at another client may be a warning sign that you are being cheated. You should also watch out for board members who are too friendly with professionals and contractors – especially if, in return for getting a job at your building, those professionals and contractors are offering extra services or “gratuities” to those board members.
Signs of the Times
There may also be opportunities for fraud because of ineffective monitoring of management or the board because:
• Board members do not have the ability to read and understand financial information supplied to them.
• The self-managed association may have no one to perform an oversight function.
• Changes in the controls were made by the management company without board approval.
• A board member, in a self-managed association without oversight, can easily circumvent internal controls.
• They’re managed by volunteers who are not aware of the need for, and methods of, establishing effective internal controls.
The purpose of the audit and the financial statement is to enable board members to understand the inner workings of the corporation or association. But it’s not easy for the layman to comprehend the financial statement (see “The Financial Statement Show,” December 2015). One thing the board can do to protect itself from fraud is to make certain that the reserve fund is not controlled by a single individual. No money should leave the reserve fund without the signatures of two board members.
Also, be sure that you receive an annual audited financial statement issued by an independent certified public accountant that is distributed to every owner with a cover letter from the auditor indicating that it is a “clean” audit. If you receive a financial statement without that and/or from someone other than an independent certified public accountant, that is a glaring warning sign.
In the end, if the signs are there, by all means investigate. But be careful: sometimes unhappy residents demand the right to review the building’s books in an endless and expensive fishing expedition to uncover wrongdoing. This is really a waste of everyone’s time and money unless the person doing the audit is a trained forensic accountant. Such an exercise disrupts the manager’s ability to manage the property, wastes the time of whoever has to obtain and monitor the records, and risks confidential information being disseminated, which could unnecessarily embarrass someone and even adversely affect the value of the apartments. If not approached seriously, this can be an avoidable nuisance. If you’re going to seek out corruption, do it the right way – or don’t do it at all.