Spotting Financial Irregularities Red Flags Every Board Member Should Know

Spotting Financial Irregularities

While it's pretty much impossible for an association board or employee to commit fraud on the scale of a Bernie Madoff or any one of the herd of shysters who have tromped through the news in recent years, building boards and managers certainly aren't above scrutiny when it comes to shady business practices. Building administrators are in positions of authority and handle large sums of money—often without a lot of supervision or oversight. Fraud and financial mismanagement in a residential building can have devastating effects on residents and building alike, but it’s more than just money; the dishonesty creates a breach of trust that can be very hard to repair.

One of the advantages of association or multifamily housing is that by pooling resources, a group of people has orders of magnitude more purchasing power than they would individually. Only the mega-rich could buy an apartment building outright. A potential downside of this arrangement is that the aforementioned pool of resources may be very deep. The notorious bank robber Willie Sutton, asked why he robbed banks, said, “That’s where the money is.” Well, that’s true of community associations and HOAs, too. 

“There’s a lot of money that flows back and forth from shareholders and owners through the management companies, who then pay it to the vendors,” says Jayson Prisand, a CPA with the accounting firm of Prisand, Mellina, Unterlack & Co., LLP in Plainview, New York. “The amount depends on the size of the entities, but it’s a significant amount of money in checks and electronic deposits.” And wherever there are large sums of money, says Sutton, there will be temptation.

How can you spot financial shenanigans—or just plain, honest mistakes? And what should you do if you suspect someone of shady dealings? Let’s take a look.

Kickback, But Don't Relax

Say a vendor puts in a bid to win a job installing new windows in your building. It's a lucrative contract, so to sweeten the pot and make sure the job gets sent his way, said vendor pads his bid by $2,000—and promises to kick that sum back to board president once the ink has dried on the contract. This scenario is known as a 'kickback,' and it’s among the more popular forms of malfeasance.

“The most common fraud is likely kickbacks from vendors for services,” explains The Condo Queens’ Karen P. Sackstein, a CPA with her own practice in Fair Lawn, New Jersey, “rendered whereby an invoice price is inflated and the difference is kicked back to either a board member or association manager.” This arrangement is not confined to board presidents, Sackstein continues. “Any position with the authority to approve vendor contracts or invoices can be subject to fraud in a kickback scheme between a vendor and another board member and/or association manager.”

Kenneth R. Friedman, a CPA and a partner with the accounting firm of Friedman, Feldmesser & Karpeles, CPA LLC in Jupiter, Florida, agrees. “While the treasurer and bookkeeper are the people typically in the best position to perpetrate the fraud because of their access to and involvement with the association’s accounting records, it really can be accomplished by any board member, since all will typically have check-signing abilities,” he says. “The association manager could also be a kickback perpetrator, since managers are typically the ones who deal with vendors and contractors.”

Kickbacks require the cooperation of vendors, but other forms of fraud are more self-contained. One of these is the so-called kiting scheme, which involves a delicate dance of bank account transfers.

“If there’s a transfer out, there should be a transfer in on the same day,” Prisand explains. “If it’s done by check, that check should be deposited fairly quickly. One scheme that we’ve seen with an agent was, they were transferring money from building A’s operating account, not to building A’s reserve account, but to building B’s reserve account. And then it went from building B to building C, and there were ways that they were shorting some money, and trying to cover it up with these transfers.” The fraudsters were taking advantage of the 'float,' the period of time where there appears to be money in an account that actually isn’t there. “It’s about dates and timing. When you get towards the fiscal year end, what could happen with an agent is, let’s say they have December year-end clients. So the balance sheet is a picture… it’s a snapshot of a point in time, like December 31st. So, say that building A has a December year-end and building B has a March year-end. Well, they don’t necessarily look as closely at building B in December, so you could borrow some money from building B to prop up building A, and then pay it back.”

Check and Double Check

Not all check fraud is this elegant. “Typically a lot of check fraud takes place, and it happens in many different ways. A lot of times there is payroll fraud, where there are ‘ghost’ employees put on the payroll, or there are additional hours put down for an employee, etc,” says Arlen S. Lasinsky, CPA, and a director of Marcum LLP, a national accounting firm. “It could be altering a check, it could be producing a counterfeit check, it could be writing a check to a fictitious vendor. Although some people would say that’s not check fraud, that’s fictitious vendor fraud. I lump it all under check fraud because the check that is written is fictitious regardless of it’s being manipulated, altered, or payable to a vendor that does not really exist.”

Some of the more creative criminals pay people who don’t exist. “For example: I’m the treasurer, and we’re self-managed. We have employees on our staff, and I do the payroll. I would never put my own name on the payroll, but if there’s a lack of oversight, why can’t I put ‘John Doe,’ or my wife’s name, or some other name? Who’s going to know? If I get that payroll check, or the money goes into my account, nobody is going to know first-hand that it happened. Now, there are ways of finding out, but no one is going to know first-hand.”

This doesn’t take into account more minor offenses, like over-ordering supplies and stealing them, or just lifting the occasional twenty from the petty cash box. 

Restoring Justice

With all this theft going on, it’s a wonder anyone ever gets paid. Fortunately, there are mechanisms to root out wrong-doing and restore justice to the building community.

"The reason any fraud takes place is a lack of oversight and a lack of internal controls,” says Lasinsky. “Typically when there’s a professional association manager, the controls are a little better, but again, the association manager is really working on behalf of the board. So if there’s a lack of oversight on the board level, the association manager is really at their mercy. Now, that being said, there have been many cases where the association manager has been the perpetrator. Obviously, there are a few bad apples in any industry you look at.” 

Ultimately, though, the responsibility—the legal fiduciary responsibility—begins with the board. “As a board member you should be getting a complete financial package every month. That comes from the professional association manager, or it’s done internally because you’re self-managed. And the package should include cash receipts journals, cash disbursements journals, financial statements, general ledger, bank statements.” These documents must be reviewed. “The bottom line is that, if I’m a board member and I see that there are checks made out to vendors that I’m not familiar with… that’s a red flag. If I see amounts that don’t really correspond to a budget… that’s also a potential issue.”

Not all potential issues are indicators of fraud. To err is human, as the old saw goes, and board members, association managers, and even CPAs are not immune to mistakes. 

“When we find something suspicious, the first thing we do is try to figure it out with management,” Prisand says. “Sometimes errors do happen. As auditors, we come in after the fact and we have to make a judgment call, whether it truly was an error or we suspect a pattern. Depending on the situation we would then proceed to the board to question what’s going on, or if they’re aware of certain transactions. Depending on what happens, the board at that point could go to the authorities, particularly if we think funds have been misappropriated or stolen.”

One smart way to safeguard against fraud is to remove the temptation. If one individual has absolute power over the finances, that individual might figure, “Why not?” So remove that absolute power. 

“Maintain proper segregation of duties, require two signatures on all checks over a certain dollar amount and for all reserve expenditures, required sealed bids for large projects from several vendors, ensure that signature cards for all bank accounts are current, regularly review financial information and obtain timely response for any unusual transactions, and of course use an experienced, industry-specific CPA firm to conduct your annual audit and to provide professional assistance as matters arise during the year,” Sackstein advises.

Fortunately, instances of fraud have declined in recent years across the tri-state area. That's a definite improvement, says Sackstein. 

“In 1994, over 80 real estate managers and management companies pleaded guilty or were charged in a corruption investigation by the Manhattan district attorney’s office [in New York City],” Sackstein says. “These charges included bribery, extortion and payoff schemes. An additional 45 managing agents from 14 companies were charged with taking millions of dollars in kickbacks from vendors seeking business in numerous cooperative and condominium buildings in Manhattan. Extensive restitution penalties were imposed. Hopefully the building boards have learned the importance of regular and ongoing oversight policies, but unfortunately, where there is greed and opportunity, these crimes will continue to be perpetrated.” More indictments from the district attorney were forthcoming in 1999 as well from a series of kickback and bid-rigging schemes. 

Nineties nostalgia is all the rage these days. Hopefully these fraudulent incidents do not happen again, but vigilance is the key to prevent that from occurring.

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