Vigilance Pays Off: How to Combat Financial Irregularity

Posted by Yugo Koshima[1]

Financial misconduct and irregularities provide a continuing headache for any government’s financial managers. They prevent a PFM system from functioning as it is supposed to do, even if the system is designed perfectly. They may also signal the existence of widespread corruption. In order to detect financial irregularities and allow policymakers to introduce preventive measures, the audit reports prepared by a country’s external audit authority are critically important.

Now consider the following questions. From which country do the following two sets of audit findings originate, and when were they prepared?

Set A 

• Two of the 81 lighthouse projects funded by the Ministry of Transportation were found to be mostly fictitious. In addition, five projects funded by an appropriation for disaster recovery were unrelated to the ministry’s mandate. 15 projects were recorded by the ministry as “completed” but showed large inconsistencies with the original design. The contractors for three projects had been paid in full, although construction work was not completed, or had not even started.
• 3,518 cases of subsidies paid by the Ministry of Agriculture to local governments for agricultural development included financial irregularities. Many local governments used the subsidies for their own hospitality or other inappropriate purposes, or distributed them to ineligible beneficiaries. In some cases, agricultural associations intermediating between local governments and beneficiaries spent the subsidies on their own operating expenses.
• The Sea Training Institute under the Ministry of Transportation conducted an unauthorized delivery business using their own training vessels, and spent the revenue on unbudgeted housing, personnel, and other expenses.

Set B 

• There were five cases of loss of public money across the entire central government, amounting in total to around US$ 220,000.
• The Police Agency overestimated the amount of payments to contractors for office demolishment by 20 percent because it made a mistake in costing the disposal of debris.
• Budget transfers to local governments for national health insurance benefits were overestimated by 0.6 percent over the last five years, because these governments made mistakes in applying the formula laid down for requesting such transfers.

What is your guess? The answer is that both sets of findings are taken from reports of the Board of Audit of Japan. Set A is an extract from audit reports of the late 1940s and early 1950s, while Set B is extracted from an audit report of 2013.

You might be surprised by the dramatic change in the audit findings during this period of over 60 years. To simplify a complex situation, many financial irregularities of the 1940s and 1950s seem to have been driven “top down” by the organizations themselves, either willfully or for lack of effective control mechanisms (see the examples of agricultural subsidies and the Sea Training Institute). In addition, because internal control over the payment process was not mechanized at this time, a large number of illegal expenditures went undetected (see the case of the lighthouse projects), and substantial amounts of public money were embezzled easily (see the case of the government trade corporation). In contrast, in 2013, financial irregularities still arise—in respect of subsidies and public investments, for example—but many of them arise from technical mistakes. A few cases of embezzlement were also reported, but the amounts lost were relatively small.

What actions were taken by the Japanese government to reduce financial irregularities over this period? A recent study[2] suggests that the following measures had an important effect:

• Liquidating and privatizing public corporations, which were an important source of financial irregularities in the earlier period.
• Introducing new legislation: a budget law adopted in 1955, for example, was effective in preventing irregularities related to subsidy schemes.
• Strengthening internal control: special audits prepared by the Board of Audit, for example, urged spending agencies to tighten the control of spending on public investment projects.
• Imposing reputational sanctions: hearings and public pronouncements issued by the Parliament, together with news reporting by the mass media were effective in discouraging irregularities and accelerating the implementation of preventive measures.

Despite these substantial improvements, the fight against financial irregularity is actually a never-ending issue in Japan. The aforementioned study points out that the schemes and devices used by fraudsters have become ever more complicated and difficult to detect. A public scandal erupts once a new case of financial irregularity emerges, only for a similar scheme to reappear after the storm blows over. To break the vicious circle of financial control and irregularity, continuing vigilance is required by the external auditor and other public bodies, not to mention the media. It is also important for the government to evaluate the effectiveness of the sanctions and other preventive measures they put in place.