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Staff Report PREPARED BY: STEPHEN CONWAY FINANCE DIRECTOR Reviewed by: Town Manager, Interim Assistant Town Manager, and Town Attorney 110 E. Main Street Los Gatos, CA 95030 ● 408-354-6832 www.losgatosca.gov TOWN OF LOS GATOS COUNCIL AGENDA REPORT MEETING DATE: 12/06/2016 ITEM NO: 8 DATE: NOVEMBER 17, 2016 TO: MAYOR AND TOWN COUNCIL FROM: LAUREL PREVETTI, TOWN MANAGER SUBJECT: RECEIVE THE FIRST QUARTER INVESTMENT REPORT (JULY THROUGH SEPTEMBER 2016) FOR FISCAL YEAR 2016/17 AND ACCEPT THE RECONCILED DEMAND ACCOUNT BALANCES (FEBRUARY THROUGH JUNE 2016) AS RESTATED FOR JUNE 30, 2016. RECOMMENDATION: Receive the First Quarter Investment Report (July through September 2016) for Fiscal Year 2016/17 and accept the reconciled demand account balances (February through June 2016) as restated for June 30, 2016. BACKGROUND: At its November 21, 2016 meeting, the Council Finance Committee heard public testimony, reviewed, and discussed the First Quarter Investment Report (Attachment 1) and the corrected February through June 2016 Reports (Attachment 2). Most of the written pub lic comments (Attachment 3), verbal testimony, and Committee discussion focused on the corrected reports. Attachment 4 contains staff responses to the questions raised in written public comments. These responses were provided verbally to the Committee. The Committee acted to move these Reports forward to the Town Council based on the information provided at the Committee meeting. PAGE 2 OF 3 SUBJECT: RECEIVE FIRST QUARTER INVESTMENT REPORT (JULY THROUGH SEPTEMBER 2016) FOR FISCAL YEAR 2016/17 DATE: NOVEMBER 17, 2016 S:\COUNCIL REPORTS\2016\12-06-16\08 Investment Report\08 Staff Report FINAL.docx 12/1/2016 6:14 PM SLL DISCUSSION: Attachment 1 contains the First Quarter Investment Report (July through September 2016). The Town’s weighted portfolio yield of 0.84% for first quarter) is still outperforming the Local Agency Investment Fund (LAIF) yield of 0.63% (difference of 21 basis points). Therefore, staff continues to replace matured or called investments with similar investments with respect to maturity and credit quality. For the quarter, the Town’s weighted average rate of return lowered by 1 basis point from 0.85% rate earned in the fourth quarter of FY 2015/16. The economic climate remains guardedly optimistic with signs of moderate growth in the gross domestic product (GDP). The United States GDP expanded at a 1.4% rate in the second quarter (April through June 2016), up from the first quarter’s rate of 1.1%. The increase beat analysts’ expectations. Consumer spending, the most important component of economic growth remained nearly unchanged. The Federal Reserve governors continue to give signals that the economy may warrant an interest rate increase as some point early next year. Staff continues to concentrate on short-term (two years or less in maturity) for its new investments with a potential shift from treasuries as they mature to high quality corporate medium term notes (higher yield). All investments are consistent with the Council adopted Investment Policy. Corrected Demand Account Balances: Staff discovered through its own internal control bank reconciliation process that there was an error in the treasurers’ cash worksheet beginning in February 2016 that caused the demand account (checking) balances to be reported too low in the Investment Reports submitted for February through June 30, 2016 of this year. The spreadsheet column for bank wires for the month erroneously omitted the wired in cash receipts for the monthly total cash receipts. Specifically, in February 2016 staff created a separate column on the treasurer’s cash worksheet for bank wire, breaking them out for tracking purposes for the Town’s books, but this column was erroneously omitted from the formula determining monthly total cash re ceipts shown on the investment report. As a result, cash receipt totals previously reported need to be corrected by increasing 2016 calendar year receipts for February ($925K), March ($1.77M), April ($4.55M), May ($1.1M), and June ($4.6M). The correction is for the cash receipts totals on the Investment Reports only. This error impacted the Investment Report only. There was no impact to the actual investment balances presented in the Report or the actual general ledger cash account balances. There was no loss of interest or any corrections required to be made to the invested balances PAGE 3 OF 3 SUBJECT: RECEIVE FIRST QUARTER INVESTMENT REPORT (JULY THROUGH SEPTEMBER 2016) FOR FISCAL YEAR 2016/17 DATE: NOVEMBER 17, 2016 S:\COUNCIL REPORTS\2016\12-06-16\08 Investment Report\08 Staff Report FINAL.docx 12/1/2016 6:14 PM SLL DISCUSSION (Continued): reported on the prior quarterly reports. There was no impact or correction required for in the Town’s official books and records. All receip ts, disbursements and demand account balances for the year included the cash wires in were correctly stated on the Town’s books. The error also had no impact on the actual investment balances (other than the demand accounts) presented in the Report. They too were correctly stated for each month of the year on the Town’s books. Unrelated to the error discussed above, there is also a year-end revision to the historical cost of cash and investments of $105,410.66 based on a final third party audit to recognize annual amortization of premiums and discounts on the portfolio , prepaid interest adjustments, and other standard bank reconciliation adjustments resulting from completed bank reconciliations for the entire FY 2015/16. This error and corrective actions to aid in preventing a future error were discussed in detail with the Town Council Finance Committee at its meeting on November 21, 2016. Attachment 4 contains detailed staff responses to questions in this regard. CONCLUSION: Staff recommends that the Town Council receive the First Quarter Investment Report (July through September 2016) for Fiscal Year 2016/17 and accept the corrected reports (February through June 2016) as restated for June 30, 2016. ENVIRONMENTAL ASSESSMENT: This is not a project defined under CEQA, and no further action is required. Attachments: 1. First Quarter Investment Report for FY 2016/17 (July through September 2016) 2. Updated FY 15/16 Investment Report second pages (February through June 2016) to reflect cash wire receipts and year-end revision 3. Public comments received on November 21, 2016 4. Staff responses to questions received from the public November 19, 2016 Re: Agenda Item #2 — Accept the Reconciled Demand Account Balances Dear Council Finance Committee, I cannot overstate the severity of having the Total Treasurer's Fund Balance for Q3 and Q4 2016 as reported in Quarterly Investment Reports understated by $2.6m and $12.4m respectively. Both of these reports were previously submitted to the Town Council and were accepted by resolutions passed on June 21, 2016 and August 2, 2016. The amount of understatement is simply stunning. It should also be pointed out that these Quarterly Investment Reports were never reviewed by the Council Finance Committee. Rather they were submitted directly to the Town Council and were accepted by unanimous vote on the consent agenda. There was no rigorous review or discussion regarding these critical financial reports prior to passing the resolution. I am writing to urge you not to accept the Staff recommendation to "accept the reconciled Demand Account Balances (February through June 2016)" until the Staff has provided written answers to at least the following questions: 1) how did this material error occur; 2) who prepared the Quarterly Investment Reports; 3) are there written accounting desk procedures requiring the Treasurer's Fund Balance as reported in the Investment Report to be reconciled on a monthly basis to the Town's accounting records and bank balances; 4) when was the error first discovered, 5) who discovered the error and under what circumstances; 6) in what demand accounts was the unreported cash deposited; and 7) what corrective actions have been taken in terms of retraining personnel and implementing additional control procedures to insure this never occurs again. The transmittal letter by the Town Manager with regard to Item 2 is silent with regard to answering these questions or providing any assurance there have been changes made to insure this mistake will not occur again. Even more troubling is the fact that the Town Manager never mentions the cumulative magnitude of the error. The only way the reader could determine that the cumulative effect of this error was $12.4m was to dig through the many pages of Attachment 2 and find it. A $12.4m error should never be deeply buried in Attachments, rather it should be boldly highlighted so this Committee fully understands the magnitude of the error. Lastly, I truly hope that the Finance Committee reflects on what has occurred and finally recognizes that the committee needs to add knowledgeable residents who can provide additional oversight. Having three knowledgeable residents on the committee, who are professionally trained in finance and accounting, who know the right questions to ask about a Quarterly Investment Report, is in itself a strong internal control procedure. A $12.4m understatement in the Treasurer's Fund which went undetected for at least 5 months, should be a wakeup call for immediate change. Sincerely, Phil Koen CC: Town Council ATTACHMENT 3 11 -21 -16 Finance Committee Meeting re year end 2015 -2016, and 1Q 2016 -2017 Attached is a short list and also a full list of questions that we have regarding the financial information to be discussed in the 11 -21 -16 meeting. The full list are additional questions, but those may be modified depending on the answers we get today. If this is the only opportunity we have to present questions, then the full list is attached at the bottom of this letter. We think the end result of this work between Staff, the Finance Committee and us will help to bring the Los Gatos financials into compliance with GASB standards. Though we would like to have all questions answered in this session, we think our total list would look like we were piling on. We're not. We're concerned residents of Los Gatos. One of our goals is to have a constructive and thought - provoking session, the answers of which will bring the town closer to full compliance with GASB, and eliminate errors in the future. Our other goal is to be helpful in solving the problems we have found and not to be viewed as a thorn in Staff's side. We all want to be proud of Los Gatos, and though the finances are generally not something the general public seeks to understand, they are very critical to the success of our town. We feel that all of these questions, once answered, and any mistakes corrected, could help to make the Los Gatos financial reporting more valuable to the Council in the management of town finances. These answers and the corrections they should bring to the statements will provide more clarity and transparency for the citizens of Los Gatos. This was promised to the town by both the Mayor Sayoc and Vice -Mayor Rennie in their acceptance speeches. Jak VanNada, Lee Fagot, Terry Duryea, Peter Hertan The Abbreviated List: Agenda Item 2: First Quarter Investment Report AND Restated Demand Account Balances (February through June 2016) We would like to understand how the misclassification between the demand account and the fund balance that was $12.4M by June 30, 2016 could go undetected for 5 months. o We view this as serious for a number of reasons: If it was due to a lack of timely account reconciliations, the foundation of any system of internal control, this represents a serious breakdown in the Town's system of internal control If the money was sitting in a non - interest bearing demand account, the error resulted in a loss of investment return Although the Town missed it, why didn't the financial institution or more importantly, the investment manager catch the error? Does the independent auditor feel he will need to disclose this as a material inadequacy in internal controls "? What changes in process and oversite are to be implemented to preclude similar future errors? Agenda Item 3: Quarterly Budget Performance & Operating Report o The following questions relate to the "box" in the Executive Summary that provides the detail of the General Fund Reserves as of June 30, 2016 in accordance with GASB #54 Both the Almond Grove Reserve and the CalPERS Reserve were established by TC resolutions, yet the former is reported as Committed and the latter is presented as Assigned. Why are they reported differently? Where is the reserve for Compensated Absences ($1,692K after being reduced by $589K to fund Almond Grove) and Vasona Land Sale ($411K) per the Oct 28, 2015 Council Resolution? Why is there not a reserve for post- retirement medical when this was recorded $400,000 as an assigned general fund reserve as of June 30, 2015. Has there been a change in spending intent? o How do the reported Q1 '16/'17 amounts reflect the unresolved employee wage negotiations? If an estimate is not provided, will the numbers be restated at a later date? o Page 3 of the Executive Summary, next to last paragraph before the US Economic Outlook indicates that $1.4 of the $3.7M Capital Improvement reserve is already committed for capital projects. What are the capital projects? The Full List (if there is time — the abbreviated list is included with the longer list that follows): Agenda Item 2: First Quarter Investment Report AND Restated Demand Account Balances (February through June 2016) There's one issue that over shadows all others. The narrative "Corrected Demand Account Balances" attempts to explain it. I will leave it up to each TC member if they think the explanation is sufficient once they understand what happened. The error is reflected in multiple places in the report when compared to the prior period reports. o On page 1, the July 31, 2016 Summary of Investment Information shows a "Last Month" balance (i.e. as of June 30, 2016) of $74,913,946. The problem is that if you look at the July 15, 2016 Fourth Quarter Investment Report that the Council approval, the June 30, 2016 balance is 62,500,546. In summary, the TC accepted a report that had bad numbers. You will see the month by month effect for the 5 months on the last 5 pages of the November 17, 2016 investment report. The collective error at June 30, 2016 was $12,413,400. o This raises the question of what happened? It appears that the staff was not reconciling the bank accounts on a regular basis. This is the most basic requirement to insure good internal accounting controls. If accounts are reconciled monthly, it should have been identified as part of the monthly closing processing. In this case, it took the Town at least 6 months to identify the problem. o It appears significant money was sitting in a "demand deposit" account, earning no interest. o Even if the Town missed it, why didn't the financial institution or more importantly, the investment manager catch the error —there was an extra 12M sitting in a demand account at 6/30/16 and no one identified it or at least called it to the Town's attention? o Fortunately, no one took advantage of the situation so no money was lost other than the opportunity loss of the interest sitting in a demand account Item 2 of the Agenda asks the Finance Committee to "receive" the fiscal Q1 16/17 report and the 5 months of Reconciled Demand Account Balances. Their appears to be a significant inadequacy of internal controls. At a minimum I would expect the Finance Committee would want to report this to the TC. I would expect the Finance Committee would want to get greater assurance that the restated numbers are now accurate. I could imagine the Finance Committee would want to talk with the Town's independent auditors to get their take on how this happened. If this is a material inadequacy in internal control, I believe the independent account needs to report it as such. The Finance Committee would want to know if this was going to happen I would expect the Finance Committee to issue a written or oral report to the TC explaining the restatements for 5 months. It would be hard to accept the report without getting comfortable in some way that the restated numbers are accurate and that new procedures are in place to ensure this does not happen again Agenda Item 3: Quarterly Budget Performance & Operating Report On a positive note - -the unaudited fiscal 15/16 showed an operating surplus of 2.66M after setting aside $2.88M of other uses (which included $2.52M to the Almond Grove Reserve" o But a question: Where is the additional $300K to be set aside in the CaIPERS Reserve" per TC authorization? o Why is there not a reserve for post- retirement medical when this was recorded $400,000 as an assigned general fund reserve as of June 30, 2015. Has there been a change in spending intent? On a positive note —the Town is reporting the components of the General Fund Reserve in accordance with GASB #54, separately identifying Committed and Assigned Reserves and the remaining Unassigned Reserve (See "Box ") o But a question —Why is the Almond Grove Reserve so much less that the 12.2M adopted at the October 28, 2015 Council Meeting? Has the Town already spent $3.7M? o Another question —Both the Almond Grove Reserve and the CaIPERS Reserve were established by TC resolutions, yet the former is reported as Committed and the latter is presented as Assigned. Why are they reported differently and how can we establish consistency? o In the 6/30/16 General Fund balance , where is the reserve for Compensated Absences ($1,692K after being reduced by $589K to fund Almond Grove) and Vasona Land Sale ($411K) per the Oct 28, 2015 Council Resolution? Do we therefore need to make up that difference, and if so, how and when will that happen? The June 2016 General Fund Reserve Report reflects the components in accordance with GASB #54 while the 2015 report reflects the components using a former standard —Could we please receive a reconciliation from the 2015 reserve presentation /classification to the 2016 reserve presentation /classification? How do the reported QI '16/'17 amounts reflect the unresolved employee wage negotiations? If an estimate is not provided, will the numbers be restated at a later date? Since the fiscal 15/16 audit has not been complete the reported numbers are unaudited, are there any remaining open audit issues at this point and if so, what are they? When do you expect the 2015/16 numbers to be finalized? What do you see as the area of greatest financial risks for the remainder of fiscal 16/17? General [Possible answers could be i) continuing decline is sales tax, ii) legal fees on North 40, iii) increased expense related to employee post- retirement benefits (pensions & OPEB), iv)... Just to note: o Per page 6, the Q1 16/17 sales tax income of $2,081K includes a one -time triple flip'true up" payment of $900K. If this is netted out, the apples to apples Q1 numbers for 2015 and 2016 are $871K for fiscal 2015 and 1,182K for 2016 o Per page 14, the left most column reflects the unaudited fiscal 2015/16 excess of revenues over expenses of $2.666M o Per page 14, the 3rd column from left and 6th column from left compare Q1 fiscal 2016 to Q1 fiscal 2017. 2016 had a deficit of $1,406K and 2017 had a deficit of $1,185K. The Q1 2016 deficit would have been $2,085K if it weren't for the one -time $900K triple flip payment explained on page 6. I don't know if Q1 2016 had any unusual items or the year to year increase in Q1 deficit of $679K is significant or if it's even an apples to apples comparison. o Per page 14, the 16/17 annual budget includes a revenue source of 8,459K for Almond Grove Project and $1.4M for Capital Projects 0 If the answers to the questions make sense, I see no reason why the Finance Committee should not "receive" the fiscal Q1 16/17. But then I'm not sure what receive" means. I would expect the Finance Committee to issue a written or oral report to the TC to explain the major changes in Q1 2016/17 which would include: o Unaudited 2015/16 results show an excess of revenue over expenditures of $2.666M Adoption of GASB 54 for General Fund reserve reporting to Town Council to be consistent with audited CAFR reporting which adopted GASB 54 in the 2012 CAFROne time $900K triple flip sale tax revenue An apples to apples year over year Q1 comparison showing a $679K greater Q1 deficit Anticipated employee costs do (do not) reflect the expected outcome of union negotiations. Report that the audit is not completed and that it is expected that it would be completed approximately XXXX On page 16 of the budget performance report, the GFAR Fund beginning balance is $14.7m. If you add the budgeted revenues of $11.3m and deduct the budgeted expenditures of $25.3m from the beginning balance, this suggests the ending balance will be $807k. Does the Town think that this is sufficient fund level to fund the future capital requirements for the Town? What should a "normal" level be for the GFAR balance be as we exit FY 2016? Why we would focus on this is that the Town has already disclosed in the 2016 Capital Plan that there is over $10m in unfunded street maintenance projects. It is hard for us to believe that drawing the GRAR down to 807,880 is prudent management. We are assuming that the entire budgeted expenditures actually get spent this year. Terry Duryea, Jak VanNada, Peter Hertan, Lee Fagot Staff Responses to Questions Posed in Public Comments 1 Question: How did this material error occur? Answer: The error only occurred in the Investment Report, with no effect on the Town’s books or investment balances as accounted for in the Town’s financial system . The Town’s independent audit firm would unlikely consider this to be a “material” error. The mistake occurred when a column was added to the Treasurer’s cash reconciliation worksheet to break out “wires in.” Adding a column for increased visibility of cash wires allowed the Finance staff to ensure proper recording of the “wires in” receipts on the Town’s books. Unfortunately, this action caused the Treasurer’s cash reconciliation worksheet to erroneously omit the column for “wires in” as a part of the total monthly cash receipts on the worksheet. The column was added in February 2016 so it affected the cash receipts presented on the prior Investment Reports for the months of February through June 2016. In summary, the cash balances were correctly accounted for on the Town books, but an error occurred on the amount presented in the Investment Report which is why it is being brought forward for correction to Town Council. Question: Who prepared the Quarterly Investment Reports? Answer: Steve Conway, the Director of Finance, gained this responsibility upon the retirement of the former elected Town Treasurer who had previously been responsible for preparing the Investment Reports. Mr. Conway prepared the recent Investment Reports and made the error in the treasurer’s cash reconciliation worksheet total column. The running cash reconciliation would typically have been cross checked against the standard monthly bank reconciliations; however, due to the staff vacancy in the Accountant position, these monthly bank reconciliations were not available by the deadline for the quarterly Investment Reports. Question: Are there written accounting desk procedures requiring the Treasurer’s Fund Balance as reported in the Investment Report to be reconciled on a monthly basis to the Town’s accounting records and bank balances? Answer: Yes. The Finance Department has written procedures for many finance processes, including bank reconciliations, daily cash receipts, and accounts receivable reconciliation. The Finance department lost two key staff positions in FY 2015/16. The most critical one was the Town’s Accountant position, leaving a six month “catch up” on the standard bank reconciliations. During this time of transition, the Director used the Treasurer’s cash reconciliation worksheet to track the daily cash balances until the bank reconciliations could be brought up to date. Unfortunately, that spreadsheet had an error but it was discovered by staff through the Town’s internal controls once the bank reconciliations were brought up to date. Attachment 4 2 Question: Who discovered the error and under what circumstances? Answer: The Director of Finance discovered the error when preparing the First Quarter Investment Report because the cash balances reported on the prior quarter Investment Report were too low based on the completed total Town cash and investment reconciled balances. Immediately upon discovery of the error, the Director informed the Town Manager and the Town’s independent audit firm of the mistake and advised that a correction of the report would be necessary and would be further explained in the First Quarter Investment Report for FY 2016/17. The circumstances were related to staff vacancies and delayed work associated with bank reconciliations as described above. Question: In what demand account were the balances deposited? Is there a loss of interest? Were the bank records correct? Answer: There was no loss of interest due to the error. The cash “wires in” were all deposited to the Town’s main checking account at Bank West Los Gatos. Interest is earned in the account and credited to the account and is used to pay for monthly bank fees. The Town needs to keep an average of $15 million in demand account compensating balances each month to avoid being charged banking fees. As stated earlier, with the error affecting the Report only, all the “wires in” were correctly accounted for by Bank West and also in the Town’s general ledger. All demand account balances were credited with interest on the correct balances to offset the monthly banking fees. Question: Should the Town’s Investment Manager have noticed the error in the Investment report? Answer: The Town reconciles its investments (not checking account balances) to the monthly Investment Manager’s reports and also the Town’s Investment Custodian (Bank of New York). The Investment Managers do not manage or reconcile the Town’s demand (checking) accounts so it is likely they would have observed the error as they have no access to the checking account balances. Question: Should the auditor make it a material finding on inadequacy of internal controls? Answer: Town staff has not received a material finding from the auditor to date. The error was discovered through the Town’s own internal control process which requires a full bank reconciliation of all bank accounts. The error was discovered by the Director in comparing the prior quarter’s investment report cash balances to the updated bank reconciliations for June 30, 2016. The mistake was limited to the Investment Report total only, it did not affect the audited Town’s books, including the cash balances or investment balances as of June 30, 2016 and had no impact to investments or investment earnings. Once the error on the report was discovered, it was immediately reported to the auditors and Town management. 3 Question: What corrective actions have been taken in terms of retraining personnel and implementing additional control procedures to insure this never occurs again. Answer: Prior to discovering the error on the Investment Report, the Director of Finance had the opportunity to work with Finance staff to bring the bank reconciliations up to date (to meet the Town’s internal control requirements and also to have accounts reconci led for the FY 2015/16 audit). The Director changed the reconciliation process from a manually intensive process on the Treasurer’s cash worksheet to an updated reconciliation process taking advantage of monthly downloads from the Town’s general ledger database and secured data monthly downloads from the Town’s bank. Finance also documented the steps in more detail in its desk procedures to aid the new staff to successfully complete the bank reconciliation in a timely manner. The First Quarter budget reports for FY 2016/17 were prepared using these revised procedures for the Town’s standard bank reconciliation of cash balances. Staff believes this type of error is unlikely to happen again under the revised desk procedures for reconciling the Investment Report.