Just how snarled Hercules municipal finances really are may never be known. After months of work by his auditors, State Controller John Chiang concluded in a that due to what he says was the deplorable condition of the city’s books it was impossible to account for at least $2 million spent during the 2009-2010 fiscal year.
The review, which focused primarily upon federal and state grant money flowing directly to the city, did not address the financial operation of Hercules’ now-defunct redevelopment agency that will be the subject of a future report. Auditors did, however, hint that discrepancies uncovered in the city’s accounting for the grant money may very well have extended to other facets of city financial operations.
But more telling was the auditorsa’ suggestion that information in financial reports from previous years was inaccurate and by implication pointed a finger at the administration of former city manager Nelson E. Oliva, who resigned in 2011 and is now the defendant in a lawsuit filed by the city alleging fraud and breach of his fiduciary duty as a public official. A spokesman for the State Controller said auditors were unable to locate Oliva to discuss their findings with him.
In fact auditors who examined the city’s financial report for the previous 2008-2009 fiscal year said several “material entries raise questions about the accuracy and reasonableness of information provided in this report.” In layman’s terms that’s a little like the IRS challenging somebody’s tax returns.
See all of Hercules Patch's coverage of the city's financial woes: Crisis in Hercules.
Yet it wasn’t the findings of Chiang’s review that upset city officials so much as the way the state controller characterized the city’s cooperation. After months of being poked and probed by state auditors, the city’s own outside accountants and FBI agents, city fathers already knew they had king-sized financial and other problems.
What sent local officials into orbit was Chiang’s not-so-subtle suggestion that city staff had stonewalled his audit team by failing to produce many requested documents and records.
“He should be ashamed of himself,” says city manager Steve Duran. “Why would the State Controller seek to punish the community, which is the only injured party, because of problems created by people who are long gone?” [His] comments are very disappointing to me. I have watched Sacramento ruin state, county and city finances in recent years - stealing funding from cities and counties while piling on unfunded mandates.
The difficulty in locating various files, Duran explained, had “to do with bad past practices” and the crush of too much work with a limited staff including preparing financial reports for last year which are seriously overdue as well as “the Ambac lawsuit, the state audit, the FBI investigation, the lawsuit against Oliva and managing the day to day finances of the City all at the same time.”
Duran said the state’s audit team outnumbered the four members of his finance department. “The final interview with state auditors had a whole different tone than [Chiang’s] “saber rattling,” he said.
“We’re going to find those records and we’re going to give them to the state controller’s office,” said Mayor Dan Romero. “I just wish he [Chiang] had been a little less political.”
Councilman Bill Wilkins isn’t at all surprised “things are being screwed up,” saying “all sorts of agencies” have been storming city hall demanding records, including the FBI which “has taken away documents for their own investigation.”
“We’re getting blasted for not finding the documents,” he said. “It appears to me that the state controller could be more helpful, instead of just playing the blame game.”
Even City Clerk Doreen Mathews, who was tasked with retrieving thousands of pages of documents for the state audit team, said she was angry over Chiang’s statements.
After receiving the controller’s request last August 30, Mathews said she provided auditors with 50 boxes of records from city hall and an offsite storage facility. A week later she provided hundreds of pages of additional documents. This, she said, was not a lack of cooperation.
"We are suffering the sins of our forefathers," said Councilwoman Myrna DeVera, who insisted there was no attempt whatsoever to stonewall state auditors as Chiang suggests. “It’s just that the records are so messed up, it's hard to reconstruct what was going on."
Implausible as that might seem, Patch's own reporting last year revealed that city council members, including DeVera, who was then mayor, were not routinely provided with the information necessary to make informed decisions about the city's financial condition.
Key to this decision-making were annual “management letters” from Hercules’ own outside auditor. Formally known as the “Management Report and Auditor’s Communication Letter,” the document is considered an integral part of annual audits and is used by auditors to address deficiencies found in a municipality’s financial operations.
The management letter accompanying the city’s financial audit for the year ended June 30, 2010 pointed to three material misstatements of facts – in accounting jargon the auditor’s way of saying the information was false. In addition, the letter from Moss, Levy & Hartzheim, a Beverly Hills accounting firm that audited the city’s books for four years before being replaced last year, highlighted a lack of city council oversight on major decisions such as competitive bidding, loan write-offs (some for affordable housing) and questionable expenditures from the city's affordable housing fund.
While Moss Levy underscored several city shortcomings in its 2010 management letter, Wilkins said it was interesting the firm didn’t find the same problems highlighted by the state controller.
Derek Rampone, a CPA with Moss, Levy who directed the annual city audits, told Patch last year his firm relied on Hercules’ own financial software system when it conducted audits, but declined to discuss details of the process even after the city, as the firm’s client, gave him permission to do so. Rampone did not return calls seeking comment on the controller’s findings.
Attempts to reach Oliva for comment were unsuccessful. Calls and email messages seeking comment from former Hercules finance director Gloria Leon, who is now the Administrative Services Director and City Treasurer for the Napa Valley City of Calistoga, were not returned.
Although management letters are public documents routinely addressed to council members, then-city officials had not been forwarding them and at first refused to provide Patch with copies, trying to claim they were confidential.
Although Chiang’s auditors concentrated on accounting for state and federal grant money, significantly their final report did make specific reference to “restatements,” adjustments and inter-fund transfers, something that was a hallmark of Oliva’s financial management almost from the moment he moved into the corner office at city hall in 2007.
Beginning with the 2007 fiscal year, annual financial reports prepared by the city’s finance department, under Oliva’s direction, suddenly became loaded with “restatements” and “prior period adjustments” -- entries used to correct accounting errors and irregularities in previous reports that may or may not have been accidental.
At the same time, the city was able to balance its budget and portray various operations as being much stronger financially than they actually were by using inter-fund transfers – moving money from one fund to another, at least on paper, and describing the transactions as loans or temporary “advances.” On subsequent financial statements the transfers would be reversed through restatements or adjustments reported deep in the fine print of footnotes to its annual financial reports.
“Unfortunately restatements and adjustments are common, we just don’t like to see them,” said Stephen L. Larson, a CPA and partner at Larson & Associates of Newport Beach, who has trained municipal officials in accounting procedures under the auspices of the California Society of Municipal Finance Officers.
“Any time there is a prior period adjustment it should be examined very closely by auditors. Adjustments are indicative of a breakdown in internal controls,” said Larson, whose former firm audited the city’s books until 2006.
Oliva’s administration made liberal use of these accounting practices for the benefit of the city’s former redevelopment agency and its municipal utility. Advances and loans between the general fund, RDA, Public Financing Authority and Hercules Municipal Utility (HMU) totaling millions of dollars were so complex and poorly documented that many city officials – including then-members of the city council – could not keep track of what was going on or were kept in the dark and never bothered to ask questions.
“There were so many inter-account transfers, it was really hard to understand what was going on,” former city councilman Don Kuehne told Patch last year.“People assume council members knew a lot more than they do.” Kuehne was recalled from office last June.
City financial reports issued between 2007 and 2010 contained more than 20 major restatements or adjustments, and inter-fund transfers became a staple of the budget process. The city’s skeletal 38-page municipal budget document for the 2010-2011 fiscal year -- the last budget Oliva prepared before his departure – contained 103 inter-fund transfers occupying seven pages.
Only once did the city's auditor publicly address concerns about questionable entries on Hercules’ financial statements related to inter-fund transfers. In the management letter accompanying its FY 2008 audit, Moss, Levy said it had discovered two “material misstatements” that would have impacted the accuracy of the financial report and city officials ultimately were required to make corrections.
Those two inaccuracies involved adjustments “for advances to/from other funds and capital assets,’’ said the auditor, but no further details were provided. According to the auditor, more specific information on the transfers appeared in financial statements for individual city funds, reports that appear to have never been publicly distributed.
Following Hercules’ convoluted money trail is reminiscent of Alice’s journey through Wonderland when it comes to separating real numbers from what former Interim City Manager Charlie Long characterized as “fantasy” numbers permeating city financial records and budget documents.
Nowhere is this confusing flow of money better illustrated than during a four-year period beginning in 2007 and particularly in 2009 and 2010 when the city’s financial acrobatics permitted HMU to transform a $1.1 deficit into a $9 million surplus in preparation for issuing $12.9 million in HMU revenue bonds. Today the electric utility is struggling and city officials are seeking a buyer.
One reason many of these HMU transfers and other financial entries might have escaped both city council and public scrutiny could have been due to the fact that sketchy details of the transactions were not always buried in footnotes to the city’s general financial reports but were contained in separate HMU financial statements. For example:
Item: The FY 2007 Financial Statements reveal
-- A $3.1 million “capital contribution” appears on the books with no explanation of its source or type
-- A $3.4 million “purchase of assets” is reported but not identified
-- A $4.6 million “adjustment” is made to account for an understatement of previous advances to HMU. This correction forced the utility to restate its 2006 assets, reducing their value from $3.3 million to $701,000 with no explanation of why the correction had to be made. By adjusting the amount of previous advances, HMU reported ending its fiscal year owing the city’s General Fund $7.4 million – an amount that in turn was listed as a receivable and reported as an asset on General Fund ledgers.
Item: The FY 2008 Financial Statements saw
-- A $1 million transfer from the General Fund to HMU, a transfer that increased the utility’s debt to the General Fund to $8.9 million with no clear explanation of the $1.5 million discrepancy between what was owed to the General Fund in 2007 and what was owed in 2008
-- A related entry, however, reports an HMU operating deficit for the year attributed “in part” to $1.2 million in revenue losses and a $286,000 payment to the General Fund, bookkeeping that seemingly accounts for the $1.5 million discrepancy in debt to the General Fund
Item: The FY 2009 Financial Statements shows
-- $5.6 million mysteriously appearing on HMU books as a “transfer in” with no explanation of its source
-- A $5.4 million “adjustment” made to correct the overstatement of amounts previously advanced to HMU with no explanation where those advances originated
-- A $4.3 million restatement of 2008 assets, again with no explanation of the circumstances requiring the correction
Thanks to these transfers and restatements, HMU was able to end its fiscal year with assets valued at $9 million, effectively setting the stage for bond sales the next year
Item: The FY 2010 Financial Statements shows
-- A $5.4 million transfer to HMU from unidentified sources allowing the utility to report year-end assets of $8.1 million, just in time for the bond issues in June and Augus
-- HMU also reports just $1.6 million in debt to the General Fund, a substantial reduction from the $4.2 million it reported owing the General Fund at end of 2009, but with no explanation of where it obtained the $2.6 million to reduce that debt
Particularly baffling was the source of the $5.4 million transfer in FY 2010 especially in light of later findings by Municipal Resource Group, a Danville consulting firm hired last year to sort through the city’s tangled finances in the wake of Oliva’s departure. MRG reported its examination found the $5.4 million had come from the proceeds of a 2005 RDA Tax Allocation Bond issue to “reimburse” the utility for past infrastructure construction.
The fact there was little documentation explaining what infrastructure had been constructed, suggests the possibility that the transfer could have been an accounting manipulation used to mask the movement of money from RDA bond proceeds earmarked for redevelopment capital projects into the HMU operating account.
By portraying the money as legitimate capital expenditures, the city would be in compliance with federal regulations prohibiting use of tax-exempt bond proceeds for operating expenses.
“Minimizing the number of transfers would provide more clarity and transparency in the budgeting process,” MRG said in its final report to the city council a year ago. “As an alternative to the current practice, the City should budget for expenses within each fund, rather than having one fund (such as the General Fund) incur expenses and then be reimbursed by other funds.”
“It’s scary what Hercules has gone through,” says Wilkins. “Unfortunately, we keep on lifting up rocks and finding new stuff. We keep on trying to pull things together and keep getting stuff dumped on us. We’re still in a state of shock.”
-Local Editor Laila Kearney contributed to this report.