 This is Stink Tech, Hawaii. Community matters here. It's Thursday again, 3 p.m., time for another Kondo Insider show. Hawaii's show about living in a Kondo association or a homeowner association. We hope you find our show interesting as we talk about industry-related topics, trying to educate our board members and owners about making their association better. All over the press we're reading today about problems with embezzlement, fraud, theft, internet issues. And so I have had the pleasure to have a great friend of mine, Dave Levy from San Francisco, who's visiting us right now, who is going to talk to us about embezzlement and fraud. And let me tell you, Dave has huge amounts of experience as a CPA with the relative issues on this matter. And we certainly want every association to be protected. So Dave, welcome to the show. Thank you. I know you have an impressive resume, but let's talk about you first. Tell me a little bit about your background and your credentials. Sure. I've been involved in the homeowner association industry for more than 30 years in Northern California. Our office does work for more than 2,000 homeowner associations. And as part of our practice, we occasionally have run into fraud and embezzlement. And at today's show, we hope to provide some answers for boards to help them avoid some of the problems that other associations have encountered. And you also do reserve studies, right? You're one of the few accounting firms that I know of. It may be the only I know that actually is engaged in the reserve studies side of the business. We do part. In California, there's a requirement to make disclosures about reserves. We don't do the actual cost estimating, but we do the financial calculations for funding the reserves. And what method do you do? Is there a method you use for funding calculations? It's essentially a cash flow methodology, which is similar to out here. Yeah, interesting enough under Hawaii law that they have under the statute two choices, one's called percent funded and one's called cash flow under the statute anyway. And I would tell you about 99% of the associations use cash flow method funding, which is under Hawaii law is a 20-year projection of your needs and your expenses, income and inflation. Sure. California is somewhat similar. We have to disclose what the percent funded is at a current point in time and our funding goes over a 30-year horizon. Yeah, and most people who have the software knows that the software itself kind of calculates out to infinity and you just select on the report how many years you want it to show, but that's all kind of a repeating type thing. Well, tell me about your firm now. Tell me some of the things you do in your firm besides audits and tax filing. Sure. Besides audits and tax returns, we do a lot of the disclosures involving reserves and what we call pro forma operating budgets in California. Essentially, at least in Northern California and throughout the state, one of the biggest financial problems for homeowners associations is in fact funding reserves. On average in California, reserves are only about 60% funded. So larger and newer associations tend to do a little bit better, but smaller and older tend to be worse. In California, there is no specific requirement for funding reserves. It's just a disclosure statute. So you could be 0% funded and so long as you disclose it, you've done what you're supposed to do. That is correct, yes. Yeah, why is it interesting in the sense that says you have to be either 50% funded or I hate to use word 100% funded because the percentage isn't going to be the right terminology. Have a cash flow plan that produces positive balances for 20 years and that's your choices. Sure. California has struggled with the funding terminology and the statutes because some people in the reserve industry will play games, but the current law simply requires that you disclose what your funding plan is and what your percent funded is today. Not that you're going to be 100% funded tomorrow, but where do you stand today and then you present what your plan is. Yeah, it's interesting under Hawaii that I say this comically, our legislature figured out how to solve that problem. We have these national standards for reserves in this national language, so they invented all their own new language. So if you read the Hawaii statute, you can't figure out how that relates to the national reserve study language, so we all end up confused. Yeah, it is very confusing for a lot of homeowners. Most homeowners do not like the word special assessment and unfortunately for many associations as they get older, if they don't have a good funding plan, that's what most of them are going to face. Can an association in California borrow money? Yes, they can't borrow money, but the way the banks look at an association, before they will loan the money, they want to see an approved special assessment to repay the bank loan. So there's no easy way out for the association. At least they can get the money immediately to fix the roof, for instance, but they have to have already approved the special assessment and the security for most banks for their loans is the right to step into the shoes of the board of directors and enforce a special assessment, if necessary, to repay their loan. That's pretty much the same in Hawaii, because you can't have a lien on the common elements. It's not like a mortgage. You can't mortgage the common elements here. They were only rights here to the cash flow from the repayment of the loan as far as collateral. Let's get into the meat of the show today, and that's fraud and embezzlement. Short answer. Do you see fraud and embezzlement? What do you do? Yes. How often? Because we deal with so many associations, we probably see it more often than some people do. Usually, it's not obvious at first glance. Some of the fraud cases we've been involved in were discovered by board members and brought to our attention. There's a common misperception by the public that when a CPA does an audit, that they're looking at absolutely everything, and that's not what an audit is. An audit is a sampling type of an approach to looking at financial transactions, and there is no guarantee that an audit will undercover fraud. CPAs are schooled to be attentive to the potential for fraud, but an audit is no guarantee that you will uncover fraud. Well, I know the word audit under the American Institute of Certified Public Accounts is a very specific protocol versus like a review or compilation, which would be a lower, I can't use the word audit, review of the financial condition than an audit. What are the basic parts of an audit in simple terms? In simple terms, what an accountant a CPA will do when he's doing an audit is look closely at cash accounts, confirm or inspect invoices and cancel checks to see that disbursements are appropriate, read board minutes, do a more detailed analytic review of transactions. So there's more work involved than a review. So unlike Hawaii in California, there's a legal requirement to review or audit if revenues exceed $75,000 for any given year. So therefore, most associations in our experience get a review not an audit because a review is cheaper than an audit. And so Hawaii may be a little bit ahead of California by requiring audits for associations larger than 20 units. Let me share with you the common misunderstanding about that in Hawaii. Our statute requires every association, every single one of the associations to annually do an audit with a CPA, except any association 20 units or less by vote of the membership, the owners, can waive doing an audit and then do something lower or nothing at all. And a lot of associations in Hawaii think because there are 20 units or less that they don't have to do an audit. Well that's true if at the membership meeting, the annual meeting or some special owners meeting, there's a motion to say I move that we don't do an audit for the year 2017. And if that was approved, then they wouldn't have to do an audit. And a lot of people just think well it only says you have to do an audit if you have more than 20 units. It doesn't say that. The statute says that everybody has to do an audit unless you have an affirmative vote by the members at a meeting to not do an audit that year. And that's kind of how our law is. For the benefit of the audience then, I will point out that two of the cases of embezzlement that we're working on currently, both with the FBI, both in progress at the moment, involve predominance of associations that are under 20 units. So just because the association is small doesn't mean that they cannot be ripped off over a period of time. And I can go into some of the detail if you would like. We'll get to that in a minute because what I want to talk about first is that we had kind of headlines here in the last six months where an association, which was self-managed, so they had their own local banking relationship and their employee general manager had a desktop or a notebook and he would do all the association's banking over the internet. I don't know about their internal best practices and protocol, but that's what they did and they suddenly decided or found out that they were missing a quarter of a million dollars. So I'm sure we're both going to agree, but maybe just comment on the fact of this, I'm going to call it internet fraud, this electronic banking fraud, the scope of it and the risk with it. Well, I'll give the audience a personal experience of my own. Occasionally people might have to pay their credit card statement or credit card bill at the last minute, and so I was in that position recently. So I take out my credit card, I look at the back, I get the phone number to call and because I hadn't done this before, I was surprised to get an automated voice and the automated voice only asked for two pieces of information, my bank routing number and my bank account number and after that I hung up the phone and the money was transferred out of my bank account to the credit card company bank account. The same general thing can work for a homeowner's association's bank account. Electronically it is not that difficult to gain access to bank accounts and that's why historically we've always been taught if your blank check stock is stolen or compromised, close the account and get a new account number and this is one of the reasons why. Kind of what you're leading into is that if you did that, it all was kosher and then someone hacked the credit card company's account and got your routing number and your bank account number, they could go into a multitude of ways and use your money without you knowing about it until you catch up with it. True. In one of the fraud cases we're involved with now, the management agent who's also got an accounting background was able to steal money simply by taking a signed check and turning the check over and endorsing it for deposit only to her account and you would think, well isn't somebody looking at the endorsement on the check? The answer is no. Nobody's looking at it. I checked this out with my FBI agent contact and he says, well, you can even make deposits with your cell phone today. That's true. There's nobody looking at the endorsement on the back of the check. Well, the one thing I want to share with our audience is a very common misunderstood issue in Hawaii is we all know under Hawaii law that both the association's board of directors or the association and the management company, if you have professional management, have to have a crime policy or a fidelity bond and everybody thinks that that covers theft. And the answer is yes, it covers theft by association employees or board members or the management company in the case of the management company's policy. This third party theft over the internet when someone's hacked your device and has stolen your money by rerouting it or whatever they do to this foreign country is not covered under the crime and fidelity policy unless you purchase third party theft coverage under the insurance policy, which is about $200 a year. And with all this internet, quote, fraud, electronic fraud today, I would think that every board member out there ought to be asking their agent, do we have third party theft cover for electronic theft? And if they don't, they ought to buy it because that's probably one of the major potential risks in the future with respect to theft. It sounds like a good thing to look into. Yeah, most people don't seem to realize that. Well, tell us about one of these FBI cases for the things you can say about kind of what the common threat is, about what the claim is, what the issue is. Okay. In another case that is currently going on, it involves about 2,000 smaller associations under 20 units for the most part. You know what I'm going to do? I'm going to stop you for one second because we're going to take a one minute break and I don't want to interrupt us in the middle, so I apologize for that. But to our audience here, we're going to be back in one minute. We're talking with Dave Levy about fraud and embezzlement and now we're going to get into the really good stuff. Living in this crazy world So far up in the confusion Making sense for me And not to be solution How to make a brighter day It's RB Kelly. I'm your host of Out of the Comfort Zone where I find cool people with cool solutions to problems that all of us face. Now the thing is, we're really cool and I only invite really cool people, but the thing is I think you're kind of cool too, so I think you should come and watch. That Thursdays at 11am here on OC16 Television with Think Tech Hawaii. I'm RB Kelly, host of Out of the Comfort Zone and I will see you next Thursday. We're back. We hope you went and got your popcorn and either a cold beverage. I prefer a beer myself. But anyway, we're talking with Dave Levy with respect to fraud and embezzlement and before I kind of interrupted him because we're going to talk about some specific cases. I asked him to tell us about an FBI case and kind of the general circumstances and so let's go back to that. Okay, great. There are two specific FBI cases that I have in mind to talk about. One was about 15 to 20 years ago and involved a property management agent who would add his name to the bank's signature card before the signature card would go to the bank. This gave him the ability to access the funds of all of his bank accounts, of all of his associations and by doing this, he was able to steal from one association at a time and every time he would get caught, which happened frequently, he would steal money from a different association to pay the money back. In the accounting world, we call that a kiting scheme and it involved a large national bank, not a homeowners association bank so they weren't very familiar with how homeowners associations worked and they were not really savvy to the fact that this manager in California should not necessarily have been signing on all the different bank accounts. I know Hawaii is a little bit different. That's true. In Hawaii, it is a little bit different in the sense that we certainly have this statute that requires a management company to keep separate accounts in the association's name but typically in Hawaii because it's run by a real estate broker who has insurance on this and bonding on this particular transaction they limit who can sign to the managing agent's principal broker because they wouldn't want a board member to be going able to go sign and check that the management company didn't know about because then you lose kind of a control of that particular operating account and money account so it's a little different. What was kind of humorous about this first case that the FBI in fact took on was the national bank, when they found out about the fraud they closed down all the accounts and opened up brand new accounts. So I found out later from one of the board members that when a board would question why was a new bank account being opened up the fraudster simply told the board well there had been a fraud in the bank and that's why the account had to be closed and yet he was still operating as the management agent. In dealing more with the technological issues and people breaking into accounts electronically a current case that is in progress right now involves a management company that had been taking funds from the associations for a number of years and once again he had access to the funds because he was on the bank signature card but the way he was stealing the money was he was providing only limited information to the boards of directors. So he would give the boards an income and expense statement each month and he would give them a falsified bank statement. Now when I was growing up a falsified bank statement meant getting out the white out and whiteing out the numbers and changing things. Well in today's world it's a little different. When the issue came up I checked with a technological consultant one of my nieces and she said well David in today's world you just get Adobe a certain kind of software and you can change the bank statements electronically print them out and you can't tell the original correct one from the falsified one and that's exactly what's happened in this current case. The management agent was simply providing an income and expense statement and a falsified bank statement to the boards each month. He was not giving them any bank reconciliation or any balance sheets. So there was no way to connect the financial statements and this was going on for a number of years and the amount of money taken exceeds a million dollars easily. How did they catch it? The first victim the unemployed wife of the board president was a young lady who was an accountant and she started raising questions and she was the first to discover that there was a problem. We were then engaged to do further inquiries and determined that yes in fact money was being stolen not only from this one association account but from others as well. So in a situation like that okay let's just say we've caught them and they're guilty and the money is missing in California do they have insurance? They protect it? Is there a recovery pot? In some cases yes. We know that one victim had a $25,000 policy with a $10,000 deductible and the insurance person contacted the FBI because the case is still going on and was convinced that yes the money had been stolen and that one association did get their money got 15 out of 25,000 back. I don't know whether there's a crime policy in California similar to what is available in Hawaii but if there is I'm definitely going to be taking that information back to my clients because it's a good idea. Well you know it's interesting you could have a $25,000 policy as you describe but if you have a million dollars lost because you haven't bought enough insurance you have a bigger problem. That is true. One of the things that's extremely important for boards is to be asking questions and looking at financial information on a regular basis. For instance in this last case if the board had gotten a copy of the bank statement directly from the bank some of this problem could have been avoided. In California and probably in Hawaii as well there's no law that says the bank has to send a bank statement directly to the board member. In my personal opinion I think perhaps legislation might help in that regard if it's at all possible. The legislation I would then want passed is that making a law that the board member has to read the bank statement and the financial statement because a lot of people just don't put any attention to it and I don't care what you wrote and might come on a piece of toilet paper they wouldn't really notice. Well that's true and I think for purposes of the viewing audience here because it is not that difficult to commit fraud or embezzlement it's extremely important that the board follow certain procedures to look at financial documents to look at bank reconciliation to look at bank statements to take the issue very seriously because there's only so much that can be done legislatively to protect an association against fraud. One of the things, I've been in the industry 25 years that I want to share this it's on point in a way to what you're talking about but there's been in my 25 years five or six thefts embezzlement fraud with management companies that I'm aware of and the most common thing that was used is what I'm going to call the fake vendor where somebody, property manager, resident manager set up a fake vendor and would charge like $38 this week $110 next week and if you're a portfolio manager making ten projects that's like $1000 a week you see and because people would say it's a small amount, no it's a $28 bills I'm not going to look into that they never really put much attention to what was being paid and the validity so comments? Yes, one of the basic accounting internal controls that CPAs are taught is that when a check is signed let's say by the board the check should go directly into the mail what can happen if it doesn't go directly into the mail it goes back to the preparer a sign check the payee could be altered by simply adding another word to the name of the payee and if a bank account is open the name of that altered payee the monies can come out and we've seen frauds happen in that way in the past as well you bring up a good point about fictitious vendors we often suggest to management company owners that they on a surprise basis accounts payable records and ask for a printout of all the vendors and see if they recognize all the names or if there's vendors that don't make any sense there's a lot of little things that can be done board members as well when they sign the form authorizing that a check be issued they should be looking at the invoice and looking to see does it make sense in some of the frauds that we've seen now the cash is being taken because bookkeeping is double entry if you take the cash out you have to kind of cover it up somehow and the somehow is often reserve expenses or miscellaneous maintenance expenses things that are not predictable so if the board is looking at their financials and comparing to budget on a monthly basis if they see fluctuations that don't make sense they should be asking questions getting near the end of the show so let me ask you if you're going to give boards two or three recommendations of simple things they can do to protect themselves what would you recommend I would say look at and understand how the financials are put together make sure that your income statement ties into your balance sheet make sure that the cash balance is on the balance sheet tie into the bank reconciliation when you're looking at the bank reconciliation that the balance per bank matches the bank statement it all fits together and the board with the assistance of their CPA can be schooled on how to recognize these things it's not that difficult but board members need to understand how it's all supposed to fit together and then look at it on a monthly basis I always recommended the boards specifically the smaller boards that maybe don't have much sophistication and accounting if you simply every month look at the check register yes good idea and you can say well here's the check we wrote and here's the amount does that make sense to me if not can you get me the invoice to support this absolutely looking at the check register both operating and reserve is important but it's not looking at one thing you have to understand how the whole process fits together and if the board is uncomfortable with it ask the CPA that they're using probably at least to do a tax return to help them I don't know if it's the law or just general operating practice in Hawaii but we have a single operating account and any disbursement has to be through the single operating account so if you had a reserve expense you would have to transfer the money to the operating account and then write the check and the transfer has a great value to everybody with respect to doing that any final comments no thank you very much for inviting me to speak today I think we should all recognize that our volunteer board members and our management companies we're talking about the exception but as a fiduciary you as a board member have an obligation to protect the association and carefully look and be responsible about really reviewing the monthly financial statement and you have a better chance then of nipping this in the bud and catching it and not opening your financials the day of the board meeting or not having a designated director who's taking a closer look at that at that point next week our show is going to be about aging in place for seniors my co-host Jane Sugimura will be back I'd like to take this opportunity to wish you a very merry Christmas and happy holidays tune in next week Aloha