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Desk Item PREPARED BY: STEPHEN CONWAY Finance Director Reviewed by: 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 DESK ITEM DATE: DECEMBER 6, 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. REMARKS: Staff appreciates the public engagement, comments, and questions regarding the Town finances. Some of the questions and comments were previously addressed in the FY 2016/17 First Quarter Investment Report and Attachment 4 (Staff Responses to Public Comments). This Desk Item is based on the request from a Council Member to address the issues raised in yesterday’s public comments. The issues focus on the Town’s financial reports, transparency, investment report error, internal controls, and unfunded pens ion liabilities. Detailed staff responses to public comments are provided in Attachment 6. Financial Reports. Staff prepares a variety of financial reports for the Town Council, including Quarterly Investment Reports, Quarterly Budget Performance Reports, and Comprehensive Annual Financial Report. Each report has a different focus and timing. Transparency. In past years, the First Quarter Investment and Budget Performance Reports were provided to the full Council as consent items. This year, the FY 2016/17 First Quarter Investment Report and FY 2016/17 First Quarter Budget Performance Report were provided t o the Council Finance Committee to receive public comment and provide an opportunity for discussion prior to consideration by the Town Council. PAGE 2 OF 3 SUBJECT: RECEIVE FIRST QUARTER INVESTMENT REPORT (JULY THROUGH SEPTEMBER 2016) FOR FISCAL YEAR 2016/17 DATE: NOVEMBER 17, 2016 N:\SHARE\COUNCIL REPORTS\2016\12-06-16\08 Investment Report\08 Desk Item FINAL.docx 12/6/2016 3:25 PM SLL REMARKS (Cont’d): This new practice provides an additional forum for public participation and engagement. Staff is recommending providing those items routinely to the Council Finance Committee prior to the full Town Council review. Council members who are not on the Committee may attend the meeting in the audience without violation of the Brown Act. As a small town, the Finance Department serves as staff for the Council Finance Committee. The Committee members do not have other staff to do this work. Investment Report Error. The mistake on the prior investment reports is discussed in detail in the FY 2016/17 First Quarter Investment Report and Attachment 4. Because there was no actual impact to the Town’s books, no loss of revenue or increased expense, the error was limited to the Investment Report only, having no effect on the First Quarter FY 16/17 Budget Performance Report. As mentioned in the staff report and Attachment 4 , staff discovered and acknowledged the error and brought the issue forward at the November 21, 2016 Finance Committee meeting. (See Staff Report Page 2) Internal Controls. As discussed in the Staff Report and Attachment 4, the Finance Department has updated its procedures and the fact that Finance staff found the error demonstrate s that the Town’s internal controls are working. The Town’s independent, third party auditor views the error as a result of a temporary delay in the completion of the bank requisitions due to a vacancy which has now been filled. The error, the temporary delay, and the staff vacancy do not affect the auditor’s opinion. As part of its responsibility under generally accepted auditing standards the Town’s independent auditor is required to have communication with Town management including communication of timely observations arising from the audit that are significant to the financial reporting process, among other requirements. Unfunded Pension Liability. There are several comments related to concerns about the unfunded pension liability. Town Council has taken actions in recent years to address this issue, including the establishment of a “pre-funding” trust for other post employment benefits (OPEB), the lump sum pay down in June 2014 of $4.5 million to fully pay off the CALPERS “side fund” pension liability related to the Town’s safety plan pension pool, and the establishment of a CALPERS pension reserve of up to $2.5 million. Staff is planning to bring forward for discussion in early 2017 recommended funding alternatives to manage a long term solution to the unfunded liabilities for both pension and OPEB. Attachment 7 contains public comment received between 11:05 a.m. December 5, 2016 and 11:00 a.m. December 6, 2016. PAGE 3 OF 3 SUBJECT: RECEIVE FIRST QUARTER INVESTMENT REPORT (JULY THROUGH SEPTEMBER 2016) FOR FISCAL YEAR 2016/17 DATE: NOVEMBER 17, 2016 N:\SHARE\COUNCIL REPORTS\2016\12-06-16\08 Investment Report\08 Desk Item FINAL.docx 12/6/2016 3:25 PM SLL Attachments (previously received with December 6, 2016 Staff Report and Addendum): 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 Attachments (previously received with December 6, 2016 Addendum): 5. Public comment received between December 5, 2016 and 11:00 a.m. December 6, 2016 Attachment received with the Desk Item: 6. Additional staff responses to public comments 7. Public comment received between 11:05 a.m. December 5, 2016 and 11:00 a.m. December 6, 2016 1 Attachment 6: Additional Staff Responses to Public Comments Received December 5, 2016 This council meeting is the only opportunity to keep the full council apprised of the financial situation of the town. The Brown Act unfortunately prohibits off-line talks and even prevents council members from attending Finance Committee meetings. Thus, everything needs to be vetted in the council meetings. Otherwise, the council only hears what the Town Manager puts in her report. It’s time to lift the curtain and get a grasp on what the public and some of the council don’t see or know. Staff Comments: The Brown Act does not prohibit any Council Members to attend to the Finance Committee meetings. If you looked at the agenda for the 11/21/16 Finance Committee meeting, you would only think that the Finance Committee was meeting to discuss the investment report and a clerical error in the Treasurers cash report. It was a $12.4 million dollar error that went on for over 6 months. Much larger issues such as bank reconciliations, misclassifications, and GASB 54 were only addressed because a group of concerned citizens had to force the discussion. As uncomfortable as it may have been for staff, changes and corrections are being made. I only wish it had not been such an uphill battle that continues as I write this. Staff Comments: Staff discovered and acknowledged the error and brought the issue forward at the November 21, 2016 Finance Committee meeting. (See Staff Report Page 2 and Attachment 4) I see little evidence of what was addressed in the Finance Committee Meeting, nor of the conversations with council, nor with staff, in the agenda for tonight’s meeting. I personally hate having to bring this up in public, and have given you a watered down speech addressing this in public. But my real issues are the items not addressed by the Chair nor the Town Manager. Suspecting that 99% of the public does not read the letters from citizens, I feel that the council’s only avenue to knowing what happened has to come from the citizens who were there and put in hundreds of hours of work. Staff Comments: Staff provided all the public comments and the summary of questions and answers in Attachment 4. … • Citizens pointed out errors in the 2015 CAFR that represent misstatements/misclassifications of the general fund reserve classifications; one totaling $2.2 million and another totaling $ 10.8 million. The council needs to know how the fixing of these classifications impacts the money available to spend on town projects. I don’t see that anywhere in the FC report. Staff Response: Staff discussed this issue on Page 2 and 3 of the First Quarter Budget Performance Report. Staff is proposing a change to its classification of the Budget Stabilization and Catastrophic reserve from “assigned” to “committed.” Neither staff 2 nor the Town’s s auditor agreed there was a misclassification, but did agree to change the classification in the soon to be completed June 30, 2016 Comprehensive Annual Financial Report (CAFR). • The citizens asked for a discussion of errors in the Treasurer’s report totaling $12,400,000 which went undetected for over 6 months and questioned internal controls that allowed this to happen. The full council should be very concerned that this oversight has been fixed and procedures in place such that it does not happen in the future. Staff Response: Staff discussed the events leading to the error and how the error on the previous reports was discovered on Page 3 of the FY 2016/17 First Quarter Investment Report. Staff has also provided written answers regarding this issue in Attachment 4. • We questioned the generally accepted practice of the Town Council (TC) approving the Treasurer’s report on the consent calendar. This is a core report which reports the total cash and investments on hand for the Town. The Council has been fully dependent on two council members to give them fully vetted financial decisions. This has not worked for at least the past year and possibly longer. A significant change needs to be made, but I don’t see that mentioned in Ms. Prevetti’s report. There is no recognition of any problems having happened. Everything seems to be just fine, until you peek under the rug. Staff Response: The Town has historically approved its quarterly investment report and the first quarter budget performance report as consent items. The FY 2016/17 First Quarter Investment Report and FY 2016/17 First Quarter Budget Performance Report were provided to the Finance Committee to provide a recommendation to the Town Council to receive those reports. This new practice provides an additional forum for public participation and engagement. Staff recommends providing those items to the Town Finance Committee prior to the full Town Council review. • We brought to the fore that Other Personnel Employee Benefits (OPEB) are also unfunded liabilities. It is footnoted in the CAFR, but not one member of the council was fully aware that it really should be a part of the UAL discussions. In my opinion, a footnoted item of this magnitude needs full exposure by the staff, and all of this needs to be spelled out in detail to the FC prior to a council meeting like this. Staff Response: Staff presentations, including a recent budget study session, have always discussed two principal unfunded liabilities, the first being the Town’s pension liabilities, the second the unfunded liability for other post employment benefits. Town Council and staff appreciate this concern and have taken actions in recent years to address this issue, including the establishment of a “pre-funding” trust for other post employment benefits (OPEB), the lump sum pay down in June 2014 of $4.5 million to 3 fully pay off the CALPERS “side fund” pension liability related to the Town’s safety plan pension pool, and this summer, as part of its budget adoption, Town Council established a CALPERS pension reserve of up to $2.5 million. Staff is planning to bring forward for discussion in early 2017 recommended funding alternatives to manage a long term solution to the unfunded liabilities for both pension and OPEB. • Several of us hope that we have raised an awareness for the need for the TC to better understand general fund reserve classifications and the difference between restricted, committed, assigned and unassigned funds and the impact they have on the ability of the town to fund projects. Staff Response: Staff discussed the various classifications of fund balances in the FY 2016/17 First Quarter Budget Performance Report (Page 2 and 3). • We questioned the appropriateness of taking assigned funds from compensated absences and post-employment medical to fund a street project. Hopefully, this is something that the council was fully apprised of and the costs in terms of dollars to the town. Staff Response: The Almond Grove funding sources were selected from table of optional funding sources presented to Town Council. Council has the authority to use re-deploy these funds from their assigned uses to other priorities. It should be noted that the compensated absences reserve has been restored to a 100% funding level as of the close of the June 30, 2016 final balances. • Unfortunately one of us had to use relentless persistence to “force” the town to comply with GASB 54. Forced is a word I use due to the lack of communication from staff and the auditor; the unusual time it took for them to admit the error; the retorts that concerned residents were off base, and finally, the capitulation that the resident had been right all along. The town has been out of compliance since the rule went into effect in 2012. Council is responsible to the correctness of the CAFR and yet, there is nothing in the FC report to let them know that they had twice approved by resolution incorrect information with this issue, and with the $12.4 million mistake. Staff Response: Staff and its independent auditor engaged multiple times with a citizen concerned about the classifications for GASB 54. After much back and forth, it became apparent that further debate was not going to be fruitful as both staff and the citizen viewed the classification issue differently. In the end, staff recommended a change going forward but did not agree the fund balances were misclassified under GASB 54. See recommended fund reserve categorization in the FY 2016/17 First Quarter Budget Performance Report (Page 2 and 3) and the previously mentioned classification change in the soon to be completed June 30, 2016 CAFR. 4 • The General Fund Reserve Policy adopted by TC 5/17/16 is still not consistent with GASB 54 and needs to be amended Staff Response: The Town’s Reserve Policy was intended to be used as a tool for managing the Town’s reserves, specifying target levels for maintaining those reserves, etc. Staff is not aware of any GASB 54 requirement specific what must be contained in a local government’s reserve policy. • Shown in spreadsheet form the “loss” of “spendable” dollars to the town manager and the council when the dollars are correctly classified. Does the council know that by correctly reclassifying the funds, that the spendable funds have been significantly reduced? Staff Response: Whenever reserve funds are utilized for purposes such as large capital projects, the reserve balances decline. Staff is not aware of any real changes to spendable dollars as a result of changing classifications between committed and assigned fund balance other than constraints (such as an approved Council resolution) as to how the reserves can be used or re-directed for another purpose. 5 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. Public Response: There is no question that the Q3 and Q4 2016 Quarterly Investment reports contain a material error by understating both the demand accounts balance and the Total Treasurer’s Fund balance. The cumulative impact of this error was $12.4m on a reported Total Treasurer’s Fund balance of $62.5m as of June 30, 2015. No serious financial professional would disagree with this view, and it is difficult to understand how the Staff has come to their conclusion. If the Town Council wishes to confirm the staff’s position, the Town Council should request the Council Finance Committee in their capacity of financial oversight to instruct the independent auditor to perform a limited review of the previously issued Q3 and Q4 2016 Quarterly Investment reports and certify that these reports were free of any material misstatement. Since these reports were officially issued by the Town, were approved by Town Council resolution and have been in the public domain and relied upon as being accurate, it is important for the Town to confirm that the Staff’s position that these reports are free of material error and can continued to be relied upon. Obviously, by the fact that the Staff is now asking the Town Council to adopt this resolution the Staff understands that this is simply not the case. The Town Council should fully understand the magnitude of publically issuing reports that have a material error and ask, “what are we now prepared to do to insure this never happens again”. 6 Staff Response: Staff commented in the staff report that since the error was limited to the Investment Report, the error had no material impact on the Town’s financial records for the year ended June 30, 2016 which remains the case. There was no financial impact from the mistake; it was a mistake on a report that once discovered required staff to have it corrected. The auditor’s audit opinion is based upon the Comprehensive Annual Financial Report for the year ended June 30, 2016, while the Investment Report is an informational report presented to Town Council that had an unintentional error that has now been corrected. With revised desk procedures and more reliance on technology, staff has just completed full bank reconciliations through October 2016. Staff used July through September 2016 bank reconciliations for its demand account balances instead of the prior practice of using the treasurer’s cash worksheet so it is very unlikely a similar mistake will occur again. 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. Public Response: The fact that the Town’s bank accounts were not reconciled on a timely basis should be of great concern to the Town Council. Timely and accurate account reconciliations is a critical internal control practice. It is a core practice in preventing and detecting fraud. There is no excuse for not having the Town’s bank accounts reconciled on a timely basis. Furthermore, these reports were never reviewed by the Council Finance Committee and were approved under the consent calendar by the Town Council. Essentially there was no serious discussion or review of these reports. There appears to have been a fundamental breakdown in the checks and controls when it came to issuing and approving these public reports. Staff Response: Staff appreciates that bank reconciliations are a vital internal control tool. It should be noted that completed bank reconciliations for FY 2015/16 were the internal control tool that discovered the error on the prior reports cash balance. As discussed with the Town Council Finance Committee, Town management was aware that there was a problem with a delay in the preparation of timely bank reconciliations. Recognizing this need the Director of Finance spent extraordinary hours helping staff streamline reconciliation processes so that the 7 reports can be prepared more timely. Desk procedures were revised to help the new staff reconcile the accounts, including cross training for additional back up to ensure the bank reconciliations are not delayed in the future. … 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. Public Response: From the staff response, it appears the error was not detected until sometime in November, 2016. This would suggest that this error went undetected for 9 months. Could the Staff please clarify exactly when the error was detected and when all of the bank accounts were fully reconciled. Staff Response: The error was discovered in early November 2016 upon staff update of the July through September 2016 Investment Report. Because of the “catch-up”, the June 30, 2016 bank reconciliation was completed by staff in early October 2016. ... Public Response: We cannot overstate the importance of timely and accurate account reconciliations. The fact that this did not occur for 6 to potentially 9 months is a material weakness in internal controls. Requiring these reconciliations to be completed by an independent person who doesn’t have bookkeeping responsibilities or check signing responsibilities and requiring supervisory review of the reconciliation is a foundational control. Designing and maintaining internal controls is a basic requirement of financial management. The independent auditor relies on these internal controls during the course of performing his audit. If these controls are insufficient or non-existent, the auditor must address this in his risk assessment and perform compensating audit procedures and additional testing. We strongly 8 encourage the Council Finance Committee to have a closed door session to discuss this issue with the auditor and become knowledgeable of the importance of strong internal controls. Staff Response: The Town has very strong separation of duties as part of its internal control process. The standard bank reconciliations have been historically prepared by the Town’s Accountant position. The delay in having reconciled reports was a temporary situation resolved in time to correct this report and staff is pleased to report all bank reconciliations are complete through October 2016. This separation of duties will be the expectation for the future, along with cross training of an additional staff person capable of this duty in the Accountant’s absence. The Town agrees that to the extent possible, with a limited staff that separation of duties and cross checks is the best way to ensure the financial records are free from error. 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 reconciled 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. Response: As was stated above, timely and accurate account reconciliations is a foundational internal control. Not having this in place increases the risk profile which the auditor must factor into his review and testing procedures. The Town Council or the Council Finance Committee should have a have closed door session without Staff present to discuss this particular issue and to engage the auditor in a broader conversation regarding the adequacy of the Town’s internal 9 controls. There is clearly an internal control issue. Proper management oversight would mandate having a deeper conversation with the auditor on these subjects. Staff Response: As part of its responsibility under generally accepted auditing standards the Town’s independent auditor is required to have communication with Town management including communication of timely observations arising from the audit that are significant to the financial reporting process, among other requirements. ATTACHMENT 7 On Mon, Dec 5, 2016 at 3:19 PM, Peter Hertan wrote: I plan to be at the DEC 6 TC meeting and plan to speak for 3 minutes on the FC report adding these two items to those communicated by Jak Vannada and Terry Duryea. . 1. The town needs to put more attention to reducing the growth of employee retirement costs because they are a growing percentage of the town budget. 2. The town needs to consider strategic alternatives in dealing with the financing of the Almond Grove streets' repaving. That is, while it is appropriate to consider the total cost of the multi year repaving and how the projected costs will grow at the expected inflation rate if some streets are delayed, that has to be balanced against the cost growth of the shortfall in payments to CalPERS which is growing at a much higher rate than inflation. Peter