Basic Recipes for Slush Funds

In the beginning, the agency managers meant to use the "unofficial" bank account for good and not for evil, as the comic book super-heroes would say. But in the end, the managers used an old family recipe to concoct a secret slush fund brew that illegally benefited a few at the expense of many.

The troubles began when a state healthcare agency's operating budget was cut and the group was denied additional funding by its governing body for the third year in a row.¹ Agency managers were desperate so they devised a plan. The chief officers of the individual offices throughout the state would be asked to help defray some of the general costs of the agency by contributing their personal checks into a secret account. The managers rationalized that they then could use this private money to bypass budget cuts, and avoid time-consuming bid requirements and other red-tape headaches. The agency's trusted bookkeeper would handle the account.

Each year, the special fund accumulated about $30,000, which would be spent during the year. Few officers asked about the use of the money and the process became automatic and routine. They were glad that there was always some extra cash for emergencies.

However, the internal auditors discovered the fund one day by accident when they saw a personal check on the bookkeeper's desk written to an unfamiliar bank account. The skeptical auditors found that most of the officers who wrote their personal checks to the fund also submitted these expenses to the county for reimbursement. In effect, they were siphoning county funds into this unofficial account.

The auditors also found that the bookkeeper had used the funds for official purposes for two years, but then she had begun to use the money for personal bills. They found payments to her mortgage company, her utility company, and other businesses. Also, some of the executives who were in the inner circle of the central office would take travel advances out of the unofficial account for legitimate travel, but then they would submit claims to the state for reimbursement and "forget" to replace the money obtained from the unofficial account.

The bookkeeper is now up for parole and some of those forgetful officers have plenty of time to sit in their jail cells and remember their misdeeds. And, in reaction to bad publicity, the agency's governing body is still denying additional funding and cutting its operating budget.

Slush fund fraud, an atypical embezzlement, is more sophisticated than merely stealing money from a company. Slush funds are unofficial accounts containing money for use in ways that shouldn't be condoned by upper management – for example, purchasing of company party supplies, plush office furniture, excessive business travel and entertainment expenses, or even legitimate needs that can't be met through regular channels.

In fact, slush fund creators frequently rationalize that the funds are necessary to avoid bureaucratic hindrances otherwise known as internal controls. These "bothersome evils" often involve requirements to bid jobs or execute purchase orders through pre-approved contracts.

Even if upper management endorses the slush fund, it usually will be concealed from the fraud examiner or auditor by misidentifying it as a "flower fund" or "water fund" or it may be totally hidden. Managers may justify concealing these funds by believing they aren't official accounts.

Because most employees in an organization aren't aware of the slush funds, it's quite easy for these accounts to be controlled by one or two people. Lured by secret available cash, custodians of these accounts often misuse the funds.
And if upper management creates slush funds or gives tacit approval, their actions give staff the impression that it's appropriate to cut corners and bend – if not break – the rules. Anyone then could question the organization's commitment to ethics, strong internal controls, and criminal laws.

Following are some common recipes for creating and protecting cool slush fund concoctions. The key component of these examples is misidentifying transactions – the true nature of the underlying transaction is misrepresented to avoid dealing with internal controls. Reviewing and understanding these methods may help fraud examiners, auditors, and managers detect slush fund schemes and help protect their organizations from this insidious type of embezzlement.

Skimming Receipts and Under-ringing Sales 

In this common method, the receipts from sales transactions are skimmed from the regular deposits to create a slush fund. The scam has a real appeal for fraudsters because they can take money before it is even recorded as having been received by the organization. This off-book fraud is much easier to conceal than money that has been recorded officially and then somehow must be taken off the books.

In this situation, the customers haven't been cheated directly. And as long as the skimmed funds are used to further the needs of the organization (a "legitimate" slush fund), the use of the funds should pose less of a threat to the future of the organization. However, all third parties relying on that organization may have to pay more for the organization's goods and services or the fraud could cause it to fail. If sales are under-reported, sales taxes will be under-collected. If the skimmed funds are used to purchase items without having to comply with bid requirements, the organization may pay a higher price for those items. Also, the institutional endorsement of such activities can have a profound negative effect on staff morale and attitudes. For example, the employee who was instructed to skim receipts on behalf of the company may decide to "go into business for himself" and possibly endanger the organization's financial health.

False Purchases  

If the first half of the basic equation for creating slush within the organization is skimming receipts, then the second half is on the disbursement side. Rather than intercepting money that is intended for the organization, the perpetrator moves the money to a slush fund by disbursing it through a misidentified transaction involving a bogus purchase. The custodian of the slush fund may submit invoices for non-delivered goods or services if there is little oversight of his actions. Otherwise, a third party may do it. The organization writes a check for the goods or services, which then is cashed and moved into the slush fund.

Another variation on this scheme involves the fraudster asking for more money than is required for the payment of the goods or services. This extra sum then is moved into the slush fund, and is used either to assist the agency in circumventing meddling internal controls, shared with the vendor, or pocketed by the slush fund's custodian.

For example, a clinic may be required to use specific funds for purchasing only certain types of medical equipment. However, employees and executives may have determined that their mission requires them to purchase other goods and services not controlled by funding restrictions. Rather than obtaining the items- that are technically unrelated to the program-through some cumbersome process, the staff might cross the line and purchase them through an authorized bank account and misidentify them as acceptable. The clinic then rationalizes that it is doing nothing wrong because, after all, it is saving lives.

Of course, once this kind of liberty is taken with the rules, a truly creative employee may do a little dealing of his own. He might establish a slush fund, and purchase the "necessary" items through it and no one asks any questions.

The perpetrator would have to go through some accounting gymnastics to cover the true activities in the fund. For instance, in the previous example of the fraudster asking for more money than is required for payment, if the overage remains in the fund, someone may notice that there aren't enough legitimate purchases recorded for the amount of money in the fund. Therefore, some of this money may be transferred to an account that is under everyone's noses – the infamous petty cash fund.

The petty cash fund is a natural for abuse. It's always available, it's liquid, it doesn't appear to be material to the auditors, and it can be used for all kinds of neat situations, such as emergency purchases. Also, reimbursement documentation is simple and only a few people maintain the petty cash fund.

The fraud examiner or auditor occasionally should consider the types of items being purchased through the petty cash fund and determine the frequency of reimbursements. In one extreme case, numerous pieces of furniture supposedly were purchased through a petty cash fund but a quick inspection of the office revealed no furniture.
Of course, any petty cash fund should be an "imprest" fund – a fund established with a certain authorized amount of cash; the fund is always maintained at that level. The fund's total, whether cash or receipts for reimbursements, always should equal the authorized amount. The fund is reimbursed whenever it is out of money. In this way, the activities in the fund can be better observed and regulated.

Double Billing 

Normally, a person who "double bills" for the same services or expenses just takes the extra money and doesn't create a slush fund. However, sometimes an individual moves the extra money into a pseudo trust fund or a slush fund.

Suppose a fraudster serves in two capacities and receives funding from two different organizations. He takes a business trip for Office A but uses Office B's credit card to charge his expenses. Office B will pay the credit card with funds earmarked for supporting the fraudster. However, he also submits a travel claim to Office A to reimburse him for what he's supposedly spent out of his pocket. Because Office A and Office B are two different entries with different payment systems, neither system communicates with the other about over-payments. As a result, the fraudster keeps the illegal reimbursement and no one detects the scam.

Overhead Allocations 

Another possible source of slush is from abusing overhead allocations. Frequently a central office will charge an assessment to the agencies it serves for administrative overhead or expenses. The share of each office's expenses may be based on square footage of space or some other measurement.

While such an arrangement would not appear initially to be unreasonable, there could be improper utilization of the assessed fees depending upon the relative power of the central office and those offices being assessed the charges.

For example, if the entire system was required to accept a budget cut of a certain percentage, the central office could perhaps avoid the entire cut by increasing the charges to the member offices. The central office then could give the appearance of accepting its fair share of the budget reduction when, in fact, it is shifting the budget reduction to other offices.

Third-party Slush Funds 

Another way to establish a slush fund is to use a third-party organization to withdraw funds from the organization where the perpetrator works.

The perpetrator needs to be trusted by both his employer and the third-party organization. Frequently the other organization is an association that supports the type of services the perpetrator's organization provides. For example, the employer may manufacture ratchets and the association is the American Association of Ratchet Makers. Depending upon the individual's roles in each organization, there may be a conflict of interest, such as when the perpetrator can control both sides of the transaction between the entities.

In one case, an association organized and held a conference, yet still had money left over in an account earmarked for conference expenses. Since the fraudster's employer financially supported the conference, the association offered to refund some of the unused money.

The fraudster, who was a volunteer officer of the association and the association's contact person with his employer, asked the association to hold the money for him. He later used the funds to purchase business airplane tickets for his staff after his employer put a freeze on travel. He then used the association's fund to pay for his personal expenses. No one at the association questioned the payments because they felt it wasn't their money and they respected the fraudster.

This type of slush fund works well because it's off the employer's books and it's maintained by another entity. However, unless the initial amount of funds in the account is large, it must be replenished frequently to be of much use. This can be done in several ways.

One scheme involves moving the funds out of an organization under the guise of a bogus purchase or payment for bogus services provided by a third party. The third party then would maintain the funds for the perpetrator until he was ready to spend more.

In order to establish this type of slush fund, the perpetrator normally would need to have approval authority with both organizations. Then he would be able to approve the payments on the front end, as well as influence the staff at the receiving organization to cooperate and not ask questions about the funding organization.

He could have the funding organization submit bills to his employer for services that never will be rendered, or in amounts exceeding the true price of the services. And he can commit the fraud if he is the individual responsible for overseeing the work and if the billing is made directly to him for approval. After he has approved the payment by his employer to the third party, he can have the proceeds from the payment deposited into "his" account with the third-party organization, pending his directions on how the money ultimately should be spent.

Another Good Source of Slush: Trash

Ultimately, the slush in slush funds is cash. But unless the cash is stolen and placed directly into the fund, originally the cash is in some other form. The cash may result from negotiable instruments such as checks written to or from the organization or it may be the proceeds from the sale of other assets of the organization.

The conversion of the asset to cash is similar to money laundering: the asset is sold and the resulting cash may not be readily traceable to the organization. The cash is much more liquid than the original asset.

One type of asset is surplus or obsolete property. Obviously, the person responsible for the assets can "dispose" of them without interference. The fraudster has at least two possible ways to squeeze some cash out of those old assets. Some materials may be truly obsolete but may have a greater intrinsic value.

In one case, the CEO of a clinic ordered a manager to "get rid of" out-dated x-rays to make room for other records and files. The films had little practical value, but the clerk realized that they contained silver and were quite valuable. She sold them to a salvage company and deposited the cash into a slush fund.

Identifying All Accounts  

Slush funds have been around since the first business exchange. Often they are established with lofty goals. However, they are designed to avoid internal controls and disguise dubious transactions. Slush funds can become havens for fraud and theft.

Fraud examiners should press an organization's staff to identify "official" and "unofficial" bank accounts and shouldn't assume that the water fund or flower fund is truly benign without some review. A quick examination of the bank statements and a surprise cash count can reassure the fraud examiner that a fund is legitimate.

Whenever a slush fund is found, the fraud examiner should investigate it to ensure that the fund's custodian has not been further corrupted by the secrecy, autonomy, and disdain for rules inherent in a bucket of slush.

1 The stories in this article are composites of slush fund case histories. 

Arthur A. Hayes Jr., CFE, is director of state audit for the State of Tennessee Comptroller of the Treasury.