June 22, 2017
The following is being shared as a courtesy to our members from the California Debt & Investment Advisory Commission (CDIAC).
In compliance with federal and state legislation, California public agencies are expected to establish and maintain internal control systems to account for and report on the expenditure of funds. There is an abundance of resources available to administrators that provide guidance on the development of internal control systems.  When applied consistently and correctly these controls can provide both the agency and the public an assurance that the funds are being properly managed and accounted for.
That being said, not all agencies apply the same system of controls they may have developed to manage general governmental funds to their bond funds. Even if they do, the system of controls used to account for and report on bond expenditures may not be fully integrated into the agency’s administrative structure even though doing so may ensure it is consistently applied.
This article is designed to provide readers a framework to understand internal control systems as they apply to bond funds and then, more importantly, present ways to bridge the gaps that often exist between a preexisting control system and the ongoing administration of bond funds.
Fundamentals of an Internal Control System
In December 2015 the Task Force on Bond Accountability released its Final Report summarizing its efforts to develop best practice guidelines on the fiduciary care and use of state and local bond proceeds.  The guideline adhered to the COSO framework for internal controls provided in the U.S. Government Accountability Office, Green Book. This consists of five elements:
Control Environment–An agency’s control environment represents the formal structures, goals, and objectives that form an internal control system. This includes the personnel–elected or appointed, the policies and procedures directing their activities in support of the control system, and the authority provided to those with oversight roles, including external bond oversight committees.
Risk Assessment–Within the context of a bond program, risk assessment is the process of identifying objectives and assessing the likelihood that risk events will occur and unfavorably affect the agency’s achievement of those objectives. The assessment of risk provides the basis for developing appropriate measures to manage risk.
Control Activities–Control activities are the actions the public agency takes through policies, procedures, and the delegation of duties to achieve its objectives and mitigate risk. The system of internal controls may vary, depending on the size, nature, and organizational complexity of the agency, but it must address the identified risks.
Information and Communications–As guardians of public funds, public agencies have a fiduciary responsibility to adopt a system of internal controls that provides a reasonable assurance that the agency is properly receiving, managing, and disbursing bond funds. Information and communication facilitates accountability and performance tracking.
Monitoring–The effectiveness of any set of internal controls is a function of its ability to mitigate risk. Since risks and program activities change over time, the internal control system must be dynamic, able to respond to changing requirements, staffing, and agency objectives. By monitoring the effectiveness of the control system, agencies can more readily adjust to these changing conditions.
Making the Control System part of the Agency’s DNA
An agency’s control system is effective only if it is consistently and universally employed. Agencies can ensure that this happens by operationalizing the control system in: 1) the agency’s plans, policies, and procedures; 2) the controlling bond documents; and 3) staff training.
Plan, Policies, and Procedures—Public agencies are guided by a number of plans, policies, and procedures when issuing and administering debt. These include a debt policy, investment policy, disclosure policy, as well as a capital improvement or facility management plan. These may be used to express elements of the control system to increase the likelihood that they will be carried out. Debt policies that call out the uses of debt, the types and terms of a debt issue, the responsibilities of the agency and staff for ongoing reporting and disclosure, the administration of debt-related payments, the uses to which the proceeds may be spent, can drive specific control activities.
Administrative policies and procedures often spell out the separation of duties between staff as well as procedures, timelines, and schedules to process specific actions. With regard to the disbursement of bond funds, for example, the agency’s policies and procedures may identify nonconforming transactions or exceptions that warrant immediate action, such as errors and discrepancies or changes in the payee name designation.
As funds are disbursed, policies and procedures may require staff to review expenditure plans, to seek legal review of contracts and agreements, to conduct site visits, and to maintain records of assets or portions of assets being financed. They may additionally set forth the content and timing of reports provided to any oversight committee or community interest groups.
Controlling Bond Documents—To strengthen compliance with policies and procedures, public agencies should integrate elements of the control system into bond documents. These include, among others, the indenture, the trust agreement, the tax certificate, the continuing disclosure agreement, and any agreements with insurers or other credit providers. The process must begin during the pre-issuance phase, during which the agency should account for all documents that will direct the roles and activities governing the investment and administration of bond funds and ongoing reporting and compliance.
Elements of the control system correspond to the specific content of most indentures, making linking the two fairly straightforward. For example, the typical indenture addresses the structure of accounts used to receive bond funds, the “waterfall” of revenues and payments, covenant restrictions, reserve maintenance and security, requirements for the disbursement of construction funds, and the terms for the trustee to safeguard and release funds. Each of these fits nicely into one or more control activities. Likewise, the trustee agreement contains terms that address financial and administrative management. Seeing that it contains language the clarifies the trustee’s role as a fiduciary when holding and investing bond funds, guaranteeing reserve requirements, monitoring bond covenants, and maintaining current balances on bond funds increases the likelihood that the agency’s control system is active and not reactive.
Agencies can use the tax certificate to establish and test control procedures to validate expenditures, including requirements for the use of proceeds, the timing of disbursement, requirements and limitations on the use of construction funds, private use restrictions, and, of course, the timing of arbitrage and yield restriction filings.
Finally, the continuing disclosure agreement provides the framework for ongoing reporting to investors and regulatory agencies and, in so doing, establishes measures to assess compliance and avoid problems. The agreement, in most cases, addresses filing requirements, the materials to be included, and the dates of submission.
Ongoing Staff Training—Public agencies can better ensure that their control system are active and employed by staff by providing training and communicating plans, policies, and procedures. Training should be provided to members of the governing body and oversight committees as well as service providers, such as auditors, who may need insights into the agency’s control system in order to perform their duties. Some agencies may need more frequent training on one or more elements of the control system. For example, agencies that use a conduit financing structure, may decide to train staff on control activities addressing expenditures and to review and update the training program to reflect improvements or changes in the control system.
Issuers enhance the expectation that they will timely and fully meet their repayment obligations through the development and application of a well-designed internal control system that tracks, monitors, and reports on the use of bond funds. Once adopted, however, issuers must take steps to institutionalize these control measures. If the agencies control system is integrated into and supported by its plans, policies, and procedures and expressed in controlling bond documents it is more likely to be applied. Furthermore, education and communication are the cornerstones of effective administrative processes. Agencies that undertake the work to articulate their control system in this manner and to train staff will undoubtedly derive material benefits in the form of better financing terms.
CDIAC has an upcoming seminar on ongoing bond administration on September 6th in Sacramento. Registration is available on CDIAC website: www.treasurer.ca.gov/cdiac.
 For information on establishing and implementing internal controls, see Standards for Internal Control in the Federal Government, U.S. Government Accountability Office (GAO), Sept. 2014, available at http://www.gao.gov/assets/670/665712.pdf, hereafter GAO Standards for Internal Control (“Green Book”); see also Gauthier, Stephen J., An Elected Official’s Guide: Internal Control, Government Finance Officers Association (GFOA), 2015, and Internal Control – Integrated Framework (2013), Committee of Sponsoring Organizations of the Treadway Commission (COSO), May 14, 2013.