Raising funds, not frauds

In my state, Washington, students in public schools conduct thousands of fundraising activities each year. Fraud examiners must understand the rules governing the entities conducting these activities to properly evaluate and investigate them.

SKIMMING IS THE FRAUD OF CHOICE

Similar to our discussion in the January/February 2013 column, fraud and abuse in all types of student fundraising activities is usually a case of simple asset misappropriation. In the ACFE’s Fraud Tree, cash schemes (part of asset misappropriations), which involve stealing an entity’s funds, fall into three categories: larceny, fraudulent disbursements and skimming. Cash larceny schemes involve the theft of funds recorded in the entity’s accounting records. In fraudulent disbursement schemes, an individual makes a distribution of entity funds for a dishonest purpose. Skimming, the theft of off-book funds, is usually at the heart of student fundraising losses.

COMMON RULES

Washington state’s administrative code establishes the general rules for fundraising activities that students conduct in public-sector schools. Of course, these rules vary in different jurisdictions. Fraud examiners in other U.S. states and in other countries should research their state and province statutes and administrative codes that apply to these activities for guidance investigating them. The following discussion presents a simple plan I’ve recommended that schools use when developing these guidelines.

A SUGGESTED PLAN FOR SUCCESSFUL FUNDRAISING

• Policies and procedures. All public entities should approve policies and procedures governing fundraising activities in the Associated Student Body (ASB) Program Fund at all schools under their jurisdiction.
• Staff training. Entities should conduct training classes for all staff who plan to manage fundraising activities. Clubs shouldn’t be allowed to hold fundraising events unless faculty advisors have received this training. Faculty advisors should sign a certificate acknowledging that they’ve been trained, read the entity’s policies and procedures and understand required fundraising events rules and consequences for breaking the rules. 
• Centralized approval system. Schools should review each club’s fundraising proposals and approve club events. Clubs must then implement plans to schedule approved fundraising events.
• Staff direction and guidance. Schools should provide direction and guidance to faculty advisors prior to approved events to ensure that they properly manage them. The advisors should provide specific prenumbered forms for each event and the methods the clubs will use to document received revenue. Just prior to each event, schools should issue a change fund to the club and require the faculty advisor to sign a receipt acknowledging accountability for both the money and the prenumbered forms for the event.
• Monitoring. After approving a fundraising event, schools should monitor all activities to ensure clubs adhere to policies and procedures. Schools should ensure that faculty advisors document accountability for received revenue, prepare activity reports for events, promptly submit all funds to the ASB Fund treasurer, and obtain receipts and keep copies of all supporting documents on file for the schools’ subsequent review and the external auditors’ audit. 
• Accountability. At the conclusion of each fundraising event, a school should analyze the outcome to ensure it’s met financial expectations and that clubs collected the appropriate amount of money, submitted it to the ASB Fund treasurer and deposited it in the bank. Schools should perform a gross profits test (see below) for each fundraising event to determine if the amount of funds received reconciles with the amount of inventory sold, if applicable. Schools also should investigate significant variances.

GROSS PROFITS TESTING

The most common weakness associated with retail sales events is that schools fail to analyze the success of each fundraising event by performing a gross profits test. Chart No. 1 below displays the computation process to determine the amount of profit or loss from a typical retail sales fundraising event.

This audit example is based on an item of resale merchandise whose cost is US$1, and whose retail sales price is US$2 — a 100 percent sales markup in cost, which represents 50 percent of the sales price. Actual merchandise information is also shown for other items, such as soft drinks and candy.

This audit example has a beginning inventory of US$1,000, purchases of US$10,000, an ending inventory of US$2,000 and a cost of goods sold (i.e.; US$9,000 at cost and US$18,000 at retail). I’ve presented computations for four different cases. The only variable in the equation is the amount of revenue actually received from the retail sales event. I’ve computed both the “net income from sales” and the “loss of funds” for each of these four cases. Case number four is the true objective of this fundraising event, while the other three cases represent losses of funds in varying degrees.

One of the interesting things that leaps out from this example is that a retail sales event can make a profit (net income) but still incur a loss of funds. Many managers find this concept hard to understand because they believe that everything is just fine as long as any profit is made. They’re wrong!

As the external auditor in my state, our agency always reported these losses at the maximum amount possible by using the computations of cost of goods sold at retail value. This loss is 100 percent cash. However, for the purposes of settlement, insurance companies want to show the loss at the minimum amount possible. Therefore, they present the loss as a 100 percent merchandise loss using the computations of cost of goods sold at cost value.

In this example, the merchandise loss amount is 50 percent of the cash loss amount. One thing about case No. 1 is certain. The merchandise loss amount is the actual amount the school spent for purchases of merchandise without receiving any revenue in return — not a single penny. This should make it very clear that we’re dealing with a real rather than a hypothetical loss of funds, as many managers would have you believe. Money was invested in inventory, which generated no revenue. Certainly, this isn’t the way to manage a retail business!

So, based upon the differences in the four cases shown above (such as retail vs. cost), it’s easy to understand why insurance companies want to start negotiating the amount of the loss as they do. They immediately take the audit loss amount and cut it in half. I believe that schools should negotiate all settlements somewhere between this minimum loss amount (all merchandise) and the maximum loss amount (all cash).

In my state, these settlements typically averaged about 75 percent of the loss amount shown in our audit reports over the years. Schools often agree to insurance company settlement offers on these terms because it’s not cost effective to try to obtain additional amounts through civil litigation. One frustrating fact that I encountered in insurance company policies was an exclusionary clause that precluded coverage for “lost profit opportunities.” When this condition exists, schools are only able to recover merchandise loss amounts from the insurance carrier.

Clubs can use the student fundraising form in Chart No. 2 below to complete gross profit testing for each retail sales fundraising event. 

LESSONS LEARNED

Let’s review some of the finer points of fraud and abuse in retail sales fundraising activities.

• Public-sector clubs and private-sector teams should plan for success when conducting retail sales events by:
• Establishing policies and procedures covering each of the types of fundraising events they plan to conduct that limit the risk of fraud and abuse and safeguard assets from loss.
• Performing gross profits testing for each event to ensure their financial expectations have been met.
• Fraud examiners should determine if public-sector clubs and private-sector teams have established plans for successful fundraising when assessing the risk of fraud and abuse in these student activities.

COMMON RED FLAGS

Part three of this series discusses common red flags of fraud and abuse in a variety of student fundraising activities for clubs in the ASB Fund of schools in the public sector. These issues come from actual case studies in my state. Fraud examiners can use these red flags to quickly assess the risk of fraud or abuse at clubs and athletic teams in your community. Get ready for some startling facts!