OFFICE OF THE INSPECTOR GENERAL
MATTHEW L. CATE, INSPECTOR GENERAL

SPECIAL REVIEW INTO CONCERNS RELATED TO
SUBSTANCE ABUSE TREATMENT CONTRACTORS

OCTOBER 2006
STATE OF CALIFORNIA

CONTENTS
EXECUTIVE SUMMARY -------------------------------------------------------------------------------------- 1
INTRODUCTION ---------------------------------------------------------------------------------------------- 4
BACKGROUND ------------------------------------------------------------------------------------------- 4
OBJECTIVES, SCOPE, AND METHODOLOGY -------------------------------------------------------- 5
FINDINGS AND RECOMMENDATIONS --------------------------------------------------------------------- 7
FINDING 1 -------------------------------------------------------------------------------------------- 7

The department overpaid three contractors nearly $5 million from fiscal year
2000-01 through 2003-04 because it did not require the contractors to reconcile
revenues to their actual costs, as required under the contracts.
FINDING 2 -------------------------------------------------------------------------------------------10

Mental Health Systems, Inc. inappropriately expensed the entire value of 22
automobiles purchased with state funds for fiscal years 2000-01 through 200304, overstating its expenses by more than $250,000.
FINDING 3 -------------------------------------------------------------------------------------------13

The department has violated state law and policy by allowing contractors to
retain ownership of potentially millions of dollars of property purchased with
state funds.
FINDING 4 -------------------------------------------------------------------------------------------16

The department may have failed to hold a contractor accountable for
mishandling confidential inmate information.
RESPONSE OF THE DEPARTMENT OF CORRECTIONS AND REHABILITATION ----- ATTACHMENT

EXECUTIVE SUMMARY
This report presents the results of a special review conducted by the Office of the Inspector
General into the Department of Corrections and Rehabilitation’s oversight of substance
abuse treatment program service providers. The providers operate under contracts with the
department’s Office of Substance Abuse Programs. The review resulted from the following
concerns raised about the actions of some of the providers by the office of Senator Jackie
Speier:
•

Mental Health Systems, Inc. may have inappropriately obtained and accounted for
vehicle purchases related to its Region IV substance abuse services coordination
agency contract.

•

Phoenix Houses of California, Inc. may have improperly disposed of equipment
when its contract for providing in-prison substance abuse treatment services at the
California Substance Abuse Treatment Facility and State Prison at Corcoran expired
on June 30, 2006.

•

Phoenix Houses of California, Inc. may have improperly disposed of confidential
records and information when its contract for providing in-prison substance abuse
treatment services at the California Substance Abuse Treatment Facility and State
Prison at Corcoran expired on June 30, 2006.

The Office of the Inspector General performed the review between July 17, 2006 and
October 16, 2006 under the authority of California Penal Code section 6126, which assigns
the Inspector General responsibility for oversight of the Department of Corrections and
Rehabilitation.
The department’s Office of Substance Abuse Programs contracts with organizations that
provide in-prison substance abuse treatment for inmates in custody and community-based
treatment services for inmates who have been paroled. The in-prison providers operate 38
therapeutic community programs at 22 institutions statewide. The programs offer inmates
four to thirty-six months of programming, and in fiscal year 2006-07 had a total bed capacity
of nearly 9,200. In each of the state’s four parole regions, the Office of Substance Abuse
Programs also contracts with organizations that serve as substance abuse services
coordination agencies to help inmates transition from in-prison programs to communitybased services. At present, the Office of Substance Abuse Programs budgets $143 million
annually to operate and oversee the drug treatment programs, with about $37 million of that
amount allocated to in-prison programs, about $60 million allocated to substance abuse
services coordination agencies, and the remaining spent on other drug treatment programs
and administration.
The Office of the Inspector General found from the review that the department’s oversight
of the substance abuse treatment contractors is lacking. The review determined that the
department overpaid three drug treatment service coordinators—Mental Health Systems,
Inc., Walden House, Inc., and WestCare—nearly $5 million from fiscal year 2000-01 through
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 1
STATE OF CALIFORNIA

2003-04 because it did not require the contractors to reconcile revenues to actual costs as
required under the contracts. The department should have compensated the providers for
the lesser of the actual costs of providing the services or an amount determined by using
rates established in the contracts. Instead, because the department did not enforce the
reconciliation requirement provided in the contracts, it paid the contractors amounts that
exceeded the actual costs of providing the services.
The review also determined that Mental Health Systems, Inc. overstated its expenses for
providing services by more than $250,000 from fiscal year 2000-01 through 2003-04 by
expensing the entire value of 22 automobiles purchased with state funds during that period.
The contractor instead should have depreciated the costs over the useful life of the
vehicles—generally established as five years.
In both cases, it appears that the time available for the department to recover the lost
amounts will expire at the end of 2006 or shortly thereafter, underscoring the need for the
department to act quickly to protect the state’s interests.
The Office of the Inspector General found in addition that the department has improperly
allowed contractors to retain ownership of potentially millions of dollars of equipment
purchased with state funds. The problem results from a line item budget guide developed by
the department that allows contractors to retain ownership of equipment purchased with
state monies if the equipment has a unit cost of less than $5,000. That provision is
inconsistent with the State Administrative Manual, which provides that any equipment
purchased or built with state funds vests in the state, and also violates the California
Constitution, which prohibits the gift of public money or anything of value to any individual
for a private purpose.
The Office of the Inspector General determined that under the provision in the
department’s line item budget guide, a contractor that had operated an in-prison substance
abuse treatment program at the Substance Abuse and Treatment Facility and State Prison at
Corcoran, whose contract was not renewed after June 30, 2006, took numerous computers,
television sets, and fax machines when it vacated the program. The contractor, Phoenix
Houses of California, Inc. kept the equipment though it had been purchased with state
funds.
The effect of the improper provision in the line item budget guide extends far beyond that
one example, however. The current budget guide has been in effect since October 2002, and
the department applies its provisions to all of its cost reimbursement contracts. In fiscal year
2005-06 alone, the department processed contracts totaling more than $2.6 billion, meaning
that the loss to the state could amount to millions of dollars.
In addition to the findings of monetary loss resulting from deficiencies in the department’s
oversight of substance abuse treatment service contractors, the special review also revealed
that the department mishandled an investigation of the improper disposal of confidential
inmate information. The department determined that confidential inmate records from a
substance abuse treatment program at the California Substance Abuse Treatment Facility
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 2
STATE OF CALIFORNIA

and State Prison at Corcoran, including names, identification numbers, ethnicities,
birthdates, release dates, and other information, was placed in the dumpster of a nearby
private business. However, the investigative services unit at the institution failed to
adequately investigate the incident and the department took no further action in the matter
despite the potential violation of federal and state law and even though the department’s
contracts with the substance abuse treatment providers include a specific provision requiring
contractors to protect confidential information against unauthorized use or disclosure.
The Office of the Inspector has issued 12 recommendations as a result of this special review.

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 3
STATE OF CALIFORNIA

INTRODUCTION
This report presents the results of a special review conducted by the Office of the Inspector
General into questions raised by the office of Senator Jackie Speier concerning the
Department of Corrections and Rehabilitation’s substance abuse programs. The review was
conducted pursuant to the Office of the Inspector General’s responsibility under California
Penal Code section 6126 for oversight of the California Department of Corrections and
Rehabilitation and its subordinate entities. The review was performed between July 17, 2006
and October 16, 2006.
BACKGROUND
The California Department of Corrections and Rehabilitation established the Office of
Substance Abuse Programs in 1989 in response to a dramatic increase in the number of
offenders committed to the state’s prisons and returning to custody because of drug-related
offenses. The Office of Substance Abuse Programs is responsible for designing, developing,
and implementing effective alcohol and drug treatment programs for inmates and parolees.
The office contracts with various organizations that provide both in-prison treatment
services for inmates still in custody and community-based treatment services for inmates
who have been paroled. At present, the Office of Substance Abuse Programs budgets $143
million annually to operate and oversee the drug treatment programs.
In-prison substance abuse treatment providers operate 38 programs at 22 institutions under
contracts with the department. The in-prison programs had a total bed capacity of nearly
9,200 inmates in fiscal year 2006-07 and account for about $37 million of the $143 million
budget. Inmates enrolled in the in-prison substance abuse treatment program participate in
four to thirty-six months of programming in “therapeutic communities.” Nationwide, more
than 250 in-prison drug treatment programs using the therapeutic community model have
been established in 40 states.
Although participation in community-based substance abuse treatment programs is
voluntary, the department strongly encourages the inmates who have participated in the inprison substance abuse treatment program to continue treatment in a community-based
program after they parole. Community-based organizations provide a variety of substance
abuse treatment programs for parolees, including residential treatment, non-residential
treatment, sober living environments, and self-help groups. The community-based
organizations operate under contracts with substance abuse services coordination agencies,
which act on the behalf of the department.
The department has contracted with organizations to serve as substance abuse services
coordination agencies in each of the state’s four parole regions. Between 1998 and 2003
three organizations––Mental Health Systems, Inc., Walden House, Inc., and WestCare—
provided these services, with Walden House Inc. serving two of the four parole regions. The
substance abuse services coordination agencies assist inmates with their transition from the
in-prison component of the substance abuse treatment program to the community-based
program and coordinate with each in-prison substance abuse treatment provider to ensure a
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 4
STATE OF CALIFORNIA

continuum of care and the integration of community services for inmates being paroled.
Each substance abuse services coordination agency refers and places parolees who have
completed the in-prison substance abuse treatment program into appropriate communitybased programs and monitors and reports to the Office of Substance Abuse Programs on
the parolees’ participation and progress in the program. The substance abuse services
coordination agencies account for approximately $60 million of the $143 million annual
budget. The department budgets approximately $46 million for other drug treatment
programs and administration.
OBJECTIVES, SCOPE, AND METHODOLOGY
The objective of this special review was to respond to concerns communicated to the Office
of the Inspector General by the office of Senator Speier about the activities of two entities
operating under contract with the department’s Office of Substance Abuse Programs. The
first concern was that Mental Health Systems, Inc., a nonprofit organization based in San
Diego, might have inappropriately purchased automobiles with state funds. Other concerns
related to the disposal of equipment and confidential records by Phoenix Houses of
California, Inc., which operated an in-prison substance abuse program for the department.
Those concerns centered on actions taken by Phoenix Houses of California, Inc. at the time
its contract with the department expired on June 30, 2006.
In the review, the Office of the Inspector General set out to answer the following concerns
raised by Senator Speier’s office:
•

Mental Health Systems, Inc. may have inappropriately obtained and accounted for
vehicle purchases related to its Region IV substance abuse services coordination
agency contract.

•

Phoenix Houses of California, Inc. may have improperly disposed of equipment
when its contract for providing in-prison substance abuse treatment services at the
California Substance Abuse Treatment Facility and State Prison at Corcoran expired
on June 30, 2006.

•

Phoenix Houses of California, Inc. may have improperly disposed of confidential
records and information when its contract for providing in-prison substance abuse
treatment services at the California Substance Abuse Treatment Facility and State
Prison at Corcoran expired on June 30, 2006.

The Office of the Inspector General expanded its review beyond these three concerns based
on issues it identified as it completed its work.
In conducting the fieldwork for this special review, the Office of the Inspector General
performed the following procedures:
•

Interviewed staff at the department’s Office of Substance Abuse Programs to gain an
understanding of its oversight over contractors.

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 5
STATE OF CALIFORNIA

•

Reviewed relevant contracts, applicable laws, policies, procedures, and other criteria
related to the functions carried out by the two identified contractors, as well as other
contractors providing similar services.

•

Interviewed appropriate staff at Mental Health Systems, Inc. and reviewed associated
financial records related to the organization’s purchase of automobiles.

•

Interviewed appropriate staff of contractors that provided services similar to Mental
Health Systems, Inc. to determine whether Mental Health Systems, Inc.’s methods of
accounting for automobile expenses were employed by others.

•

Interviewed key department and contractor staff at the California Substance Abuse
Treatment Facility and State Prison at Corcoran and reviewed relevant documents to
determine the appropriateness of the actions of Phoenix Houses of California, Inc.
in disposing of equipment and confidential program information when its contract
for providing in-prison substance abuse treatment services at the California
Substance Abuse Treatment Facility and State Prison at Corcoran expired on June
30, 2006.

•

Analyzed the information gathered through the above procedures and formulated
conclusions.

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 6
STATE OF CALIFORNIA

FINDING 1
The Office of the Inspector General found that the department overpaid three
contractors nearly $5 million from fiscal year 2000-01 through 2003-04 because it did
not require the contractors to reconcile revenues to their actual costs, as required
under the contracts.
The California Department of Corrections and Rehabilitation failed to require the three
substance abuse services coordination agency contractors—Mental Health Systems, Inc.,
Walden House, Inc., and WestCare—to reconcile revenues with actual costs as specified in
their contracts. As a result, the department overpaid the contractors nearly $5 million over a
four-year period. The contracts provided for the three companies, which act as the substance
abuse services coordination agencies, to receive compensation using rates established in the
contracts for the various services they provided—coordinating the continuance of substance
abuse treatment for inmates who are being paroled into the community. The contracts also
required the service coordinators to periodically reconcile revenues received with actual costs
of providing the services, and if revenues exceeded actual costs, for the difference to be
refunded to the department. Put another way, the contracts called for the department to
compensate the service coordinators for the lesser of the contractors’ actual costs of
providing services or an amount determined by using the rates established in the contract.
Because the contracts in question spanned the period December 1, 1998 to December 31,
2003, and because the contracts may be subject to review for only three years after final
payment of the contract, the time remaining for the department to recover the nearly $5
million in overpayments may be short.

The department did not require the contractors to perform reconciliations. Because
the department did not require the service coordinators to perform reconciliations between
revenues and actual costs to determine the method that resulted in lower costs, the
department paid the contractors amounts that exceeded the actual costs of providing the
services. As shown in Table 1, the service coordinators’ revenues under the contracts
exceeded their actual costs in each of fiscal years 2000-01 through 2003-04. Totaled together,
the overpayments amounted to nearly $5 million.
According to the chief financial officer of Mental Health Systems, the company did not
perform the reconciliation because it was the understanding of his staff from reading the
contract and from discussions with the department’s Office of Substance Abuse Programs
that the reconciliation was not required. A review of the contract, however, shows that such
reconciliation was clearly required. As discussed later in this report, Mental Health Systems
believed the contract was a “fee-for-service” type contract––which bases revenue on the
completion of services, compensated at established rates––rather than a cost reimbursement
type contract––which bases compensation on the actual costs of providing services.
In fact, the contracts under which Mental Health Systems and the other service coordinators
operated during this period required contractors to follow a hybrid approach to determine
compensation. The contracts provided that the service coordinators be initially compensated

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 7
STATE OF CALIFORNIA

using agreed-upon rates for the services they provided––which is consistent with a fee-forservice contract.
However, the contracts also called
for the service coordinators to
periodically reconcile contract
revenue received—using the
established rates—to the actual
costs of providing the services. If
the actual costs were less, the
difference was to be repaid by the
contractor. Under this hybrid
approach, the service coordinators
were to be paid the lower of either
the established rates or the actual
costs of providing services.

The contracts required
reconciliations. For these

TABLE 1
SERVICE COORDINATORS’ REVENUES AND EXPENSES
FISCAL YEAR
REVENUES
EXPENSES
EXCESS
REVENUE
2000-01
Mental Health
Systems
$ 1,425,479
$1,407,867
$ 17,612
5
Walden House
11,792,041
11,561,808
230,233
1
1
1
WestCare
985,467
535,964
449,503
2001-02
Mental Health
Systems
1,837,829
1,743,840
93,989
5
Walden House
15,102,112
14,600,386
501,726
2 10,375,361
2 9,269,535
2 1,105,826
WestCare
2002-03
Mental Health
Systems
2,919,343
2,581,275
338,068
Walden House5
13,354,951
12,649,924
705,027
3 9,983,456
3 8,922,713
3 1,060,743
WestCare
2003-04
Mental Health
Systems
1,612,981
1,531,443
81,538
5
Walden House
6,148,377
5,741,495
406,882
4
4
4
WestCare
Totals
$75,537,397
$70,546,250
$4,991,147

contracts, the department chose
to compensate the service
coordinators through separate
contractors that operated inprison substance abuse treatment
programs at various prisons
throughout the state. Under that
arrangement, the department
provided funding to the in-prison
1 WestCare could not provide complete accounting records for fiscal year 2000-01.
treatment providers, who then
Shown here is information for the period January through November 2000.
subcontracted with the service
2, 3 WestCare’s fiscal year spans January through December. Shown here is information
coordinators to provide substance
for the periods:
2 January through December 2002.
abuse coordination services to
3 January through December 2003.
inmates who paroled to the
4 Information from July 2003 through December 2003 is included in 3 above.
service coordinators’ designated
5 Walden House provided services in two separate parole regions.
geographical regions. In its
Source: Contractors’ unaudited financial records.
contracts with the in-prison
treatment providers, the
department clearly required providers to ensure that the service coordinators performed
periodic reconciliations of revenues with actual costs of providing services. Specifically, the
contracts provided as follows:
The Contractor shall have the fiscal capacity to assure that [substance abuse services coordination
agency] reimbursements can be made … The fiscal system shall allow an interim reimbursement
based on units of service provided, so long as final reimbursement is based on the lower of actual cost
or the established rate per unit of service. The [substance abuse services coordination agency] shall
provide for a database on participant services which may be used for this purpose. The database shall
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 8
STATE OF CALIFORNIA

contain at least the following data elements: … the costs for the services, pending settlement to the
lower of price per unit of service or actual cost of services.
The contracts further provided:
The agreements between the in-prison Contractors and the [substance abuse services coordination
agencies] shall contain [among others] a description of the system for reimbursement of [substance
abuse services coordination agencies] for services provided to or purchased for participants, including
how reimbursement will be reconciled to the lower of fixed price or actual cost.
The Office of the Inspector General found in addition that contracts Mental Health Systems
made with the various in-prison treatment providers to receive substance abuse services
coordination agency funding included the requirement that Mental Health Systems reconcile
revenues with its actual costs and refund the difference. Indeed, five of these contracts were
between Mental Health Systems, in its role as an in-prison treatment provider at four
different prisons, and itself, as a substance abuse services coordination agency.

Because the reconciliations were not done, the department overpaid the contractors.
It is clear therefore that the service coordinators received excessive revenue in fiscal years
2000-01 through 2003-04, as shown in Table 1. In addition, Mental Health Systems
overstated its expenses during this time period by more than $250,000, an issue discussed in
more detail in Finding 2 of this report. The effect of the overstated expenses, with the
excessive revenues discussed above, brings the amount the department inappropriately paid
Mental Health Systems to more than $780,000.
The department changed its method of contracting with service coordinators in January
2004 to eliminate the reconciliation requirement. The department structured each of the
service coordinator contracts that went into effect on January 1, 2004, so that the
department made payments directly to the service coordinators rather than paying them
through the in-prison treatment providers. The department also revised the method of
compensating service coordinators to solely cost-reimbursement. Therefore, the
reconciliation requirement that existed in the previous contract under the hybrid approach to
compensation no longer exists and the possibility of future overpayments resulting from the
reconciliation problem has been eliminated.

Time may be short for the department to recover past overpayments. It appears that
the period available for the department to recover the past overpayments may be rapidly
coming to a close. Under state law, the department has until December 31, 2007 to file legal
claims against the contractors, but the contractors may not be required to retain contractrelated records that long. The department’s contracts with the substance abuse services
coordination agencies do not clearly specify how long the contractors must retain records
related to operations under the contract, but do contain a provision that subjects the
agencies to review by the California State Auditor for three years after final payment under
the contract. Because the initial contracts ended on December 31, 2003, with final payments
probably occurring sometime soon afterward, the three-year period will end on December
31, 2006 or shortly thereafter. Also, the department’s line item budget guide—which
provides guidance for contractors to follow in determining allowable costs under cost
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 9
STATE OF CALIFORNIA

reimbursement contracts with the department—provides that audits and reviews may be
conducted at any time during the performance of the contract or during the three years
following the end of the contracting period. Although the department did not incorporate
the line item budget guide into the initial service coordinator contracts, it has incorporated
the guide into the current service coordinator contracts and other substance abuse contracts.
The budget guide may therefore provide guidance in determining the period during which
the service coordinators are subject to review and audit. Under the provisions of the budget
guide, the period for audit and review of the initial service coordinator contracts would end
on December 31, 2006, meaning the department will have to respond quickly if it is to
protect the state’s interest in this matter.
Finally, the department’s contracts with the service coordinators include a dispute clause in
which both parties agree to resolve claims or disputes arising under the contracts pursuant to
the provisions contained in the department’s operations manual. The operations manual
provides for informal and formal appeals that contractors can submit to department
management in the event of a claim or dispute. It also acknowledges either parties’ right to
pursue legal remedies through arbitration or litigation. In the event of litigation, section 337
of the Code of Civil Procedure establishes a statute of limitations of four years from the date
of the last payment made under the contract. The statute of limitations for legal action
under the service coordinator contracts would lapse on December 31, 2007, or shortly
thereafter.
RECOMMENDATION
The Office of the Inspector General recommends that the department require
the substance abuse services coordination agencies to reconcile revenues
received during the contracts covering the period December 1, 1998 to
December 31, 2003 with the actual costs of providing the services and refund
any excess revenue received during that period.
FINDING 2
The Office of the Inspector General found that Mental Health Systems, Inc.
inappropriately expensed the entire value of 22 automobiles purchased with state
funds from fiscal year 2000-01 through 2003-04, overstating its expenses by more than
$250,000.
Mental Health Systems Inc., which coordinates the continuance of substance abuse
treatment for inmates who are being paroled into the community, overstated its expenses by
more than $250,000 over a four-year period when it charged the entire value of the
automobiles at the time of purchase instead of depreciating the costs over the useful life of
the vehicles.
Mental Health Systems has functioned as a substance abuse services coordination agency for
the California Department of Corrections and Rehabilitation since December 1, 1998. In
that role, Mental Health Systems contracts with community-based substance abuse treatment
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 10
STATE OF CALIFORNIA

providers to provide services to paroling inmates, and then coordinates with in-prison
treatment providers to facilitate the transition of the inmate from the in-prison substance
abuse treatment programs to community-based programs. The initial contract between the
department and Mental Health Systems spanned December 1, 1998 to December 31, 2003.
Mental Health Systems received a new contract to continue in this role beginning January 1,
2004 and continuing through December 31, 2006.

Mental Health Systems had a clear need for transportation. As part of its
responsibilities under the contracts, Mental Health Systems provides transportation to
paroling inmates and makes visits to monitor the parolees’ progress in the community-based
substance abuse treatment programs. Accordingly, Mental Health Systems had a need to
acquire a means of transportation for its staff to carry out these responsibilities. Mental
Health Systems chose to purchase automobiles to meet its need for transportation under the
contract. During fiscal years 2000-01 through 2003-04––the span of its initial substance
abuse services coordination agency contract––Mental Health Systems purchased 22 vehicles
and recorded the related costs as expenses in its accounting system under its substance abuse
services coordination agency operation.

Mental Health Systems recorded the costs improperly. As shown in Table 2, however,
rather than depreciating the costs of the automobiles over the useful life of the vehicles,
Mental Health Systems expensed the
TABLE 2
entire cost of the automobiles at the time
AUTOMOBILES PURCHASED BY MENTAL
of purchase. Under the contract, Mental
HEALTH SYSTEMS
Health Systems was required to adhere to
NUMBER OF
TOTAL
generally accepted accounting principles
FISCAL
AUTOMOBILES
AMOUNT
as outlined by the American Institute of
PURCHASED
EXPENSED
YEAR
Certified Public Accountants. A generally
2000-01
1
$24,859
accepted accounting principle called
2001-02
6
82,267
“matching” requires each expense item
2002-03
9
143,489
related to revenue earned to be recorded
2003-04
6
80,215
in the same accounting period as the
Totals
22
$330,830
revenue it helped to earn. If this is not
done, the financial statements will not
measure the results of operations fairly. Because the automobiles were to be used by Mental
Health Systems to deliver services in periods beyond the period in which they were
purchased, to appropriately account for the vehicles, Mental Health Systems should have
capitalized and depreciated the automobiles over their useful lives.

Mental Health Systems mistakenly believed the contract was “fee-for-service.”
According to the chief financial officer of Mental Health Systems, the company believed that
the original contract was a fee-for-service contract, and as such, there were no limits on how
it could use the earned funds once Mental Health Systems provided its services.
Accordingly, Mental Health Systems expensed the entire cost of the automobiles at the time
of purchase. The chief financial officer told the Office of the Inspector General that this
conclusion was based on the company’s understanding of the contract as well as discussions

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 11
STATE OF CALIFORNIA

between its staff and representatives of the department’s Office of Substance Abuse
Programs.
As discussed in Finding 1, however, the contract under which Mental Health Systems
operated during this period requires it to follow a hybrid approach to determine its
compensation. The contract provides that Mental Health Systems can be compensated using
agreed-upon rates for the services that Mental Health Systems provided––which is
consistent with a fee-for-service contract—but the contract also called for Mental Health
Systems to periodically reconcile contract revenue received using established rates to its
actual costs of providing the services. If actual costs were less, the difference was to be
repaid by Mental Health Systems to the department. Under this hybrid approach, Mental
Health Systems was to receive the lower of the established rates or its actual costs of
providing services.
To perform the reconciliation, Mental Health Systems would have needed to record costs
accurately and appropriately to determine the actual costs of providing services––including
transportation. Because it did not follow generally accepted accounting principles in
recording the automobile purchases, Mental Health Systems’ costs were not accurately
stated, but instead were overstated.

Mental Health Systems overstated its expenses by more than $250,000. As shown in
Table 3, when the amounts Mental Health Systems inappropriately recorded as expenses
during the period of the initial substance abuse services coordination agency contract are
reversed, and the proper amounts are applied using generally accepted accounting principles,
it becomes clear that Mental Health Systems overstated its expenses by more than $250,000.
TABLE 3
CHANGES NEEDED TO ACCURATELY REFLECT AUTOMOBILE EXPENSES
FISCAL YEAR
2000-01
Recorded
Expenses
Proper
Depreciation **
Difference –
Amount Expenses
Overstated

2001-02

2002-03

2003-04*

TOTALS

$24,859

$82,267

$143,489

$80,215

$330,830

414

6,343

24,823

41,000

72,580

$24,445

$75,924

$118,666

$39,215

$258,250

* This period covers July 1, 2003 through December 31, 2003, which is when Mental Health Systems’ initial contract
terminated.
** The Office of the Inspector General calculated depreciation using straight line depreciation over a five-year life. The
five-year life is commonly used for business automobiles and appears reasonable in this case because Mental Health
Systems told the Office of the Inspector General that most of the vehicles are still in use.

Mental Health Systems’ current contract does not authorize depreciation. Using
generally accepted accounting principles, Mental Health Systems would be able to continue
depreciating its automobile expenses under its current substance abuse services coordination
agency contract, which began on January 1, 2004, because it continues to use most of the
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 12
STATE OF CALIFORNIA

vehicles it purchased. Under the terms of that contract, however, Mental Health Systems
must obtain advance authorization from the department to charge costs, such as
depreciation of automobiles. Mental Health Systems did not include such a request in that
contract. According to the chief operating officer of Mental Health Systems, it would have
included a request for depreciation of its automobiles if it had been aware at that time that it
had inappropriately expensed its automobiles. Nonetheless, because Mental Health Systems
did not request authorization for such costs in its current contract, it is not allowed to charge
them to this contract, which spans January 1, 2004 through December 31, 2006.
As discussed in Finding 1 of this report, Mental Health Systems based its billings for its
substance abuse services coordination agency activities on established rates but did not later
reconcile its actual costs to revenue it received. Since Mental Health Systems did not
perform the reconciliation, its actual costs had no impact on the amount of revenue it
received. Therefore, Mental Health Systems’ improper recording of the expenses related to
its purchases of automobiles did not result in the company requesting and receiving
excessive program revenues. However, when the department requires Mental Health
Systems to reconcile its actual costs of providing services with its revenue received using
established rates, as discussed in Finding 1, the department should ensure that Mental Health
Systems adjusts its actual costs of providing services during those periods to accurately
reflect the cost of the automobiles, as described in Table 3 above.
RECOMMENDATIONS
The Office of the Inspector General recommends that the department require
Mental Health Systems to restate its expenses to record the costs of its
purchases of automobiles in accordance with generally accepted accounting
principles.
The Office of the Inspector General also recommends that the department
ensure that Mental Health Systems uses its adjusted actual costs of providing
services during these periods when reconciling its revenues to actual costs.
FINDING 3
The Office of the Inspector General found that the department violated state law and
policy by allowing contractors to retain ownership of potentially millions of dollars of
property purchased with state funds.
The California Department of Corrections and Rehabilitation has developed a line item
budget guide for contractors to follow in determining allowable costs under cost
reimbursement contracts with the department. In violation of state law and policy, however,
the department included a provision in the budget guide that allows contractors to retain
ownership of equipment purchased with state funds if the equipment has a unit cost of less
than $5,000. As a result, the department has given away state equipment costing potentially
millions of dollars.

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 13
STATE OF CALIFORNIA

The department developed the budget guide to assist contractors in following the
department’s requirements related to cost reimbursement contracts. The budget guide is
incorporated into the department’s cost reimbursement contracts by reference and provides
detailed guidance to contractors in determining what costs are allowable to be reimbursed
under the contract. The budget guide includes information related to costs for items such as
personnel, staff benefits, subcontractors, and operations.

The budget guide allows contractors to keep certain equipment items. Within the
section of the budget guide that discusses operating costs, the department has included a
discussion of costs related to supplies and expendable equipment. That discussion includes
the following statement:
Expendable equipment purchased will remain the property of the Contractor. Expendable
equipment is defined as having a unit acquisition cost of less than $5,000 per unit. [Emphasis in
original]
This provision allows contractors that purchase equipment costing less than $5,000 with
state funds to retain ownership of the equipment. Accordingly, a contractor that operated
an in-prison substance abuse treatment program at the Substance Abuse Treatment Facility
and State Prison at Corcoran—Phoenix Houses of California, Inc.—whose contract was not
renewed after June 30, 2006, took numerous computers, television sets, and fax machines
when it vacated the program. Since it is likely that none of the items had a unit value of
$5,000 or more, the contractor retained ownership of the equipment under the provision in
the budget guide, even though the equipment was purchased with state funds.

The budget guide provision violates state law and policy. The provision is contrary to
the State Contracting Manual, which is incorporated into the State Administrative Manual.
Specifically, section 7.29 of the State Contracting Manual provides as follows:
When equipment is purchased or built with state funds as part of the contract [,] the contract must
state that title to any equipment purchased or built with state funds will vest in the state [Emphasis
added]. On termination of the contract, the state may:
1. Request such equipment be returned to the state, with the costs incurred by the contractor for
such return being reimbursed by the state.
2. Authorize the continued use of such equipment for work to be performed under a different
agreement or contract.
In addition, the California Constitution, Section 6, Article XVI, prohibits the giving of any
gift of public money or anything of any value to any individual for a private purpose. This
constitutional prohibition is designed to ensure that the resources of the state are devoted to
public purposes. It is therefore improper for the department to include a provision in its
budget guide that allows contractors to retain ownership of equipment with a unit value of
less than $5,000.
According to a senior management auditor in the department’s Office of Audits and
Compliance, the department included this provision in the budget guide because the State
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 14
STATE OF CALIFORNIA

Administrative Manual does not require state agencies to track equipment that costs less
than $5,000. The auditor asserted that equipment costing less than $5,000 is synonymous
with supplies and therefore remains the property of the contractor, adding, “the department
is not in the business of retaining used expendable equipment.”
It appears that the department mistakenly applied policies intended for state agencies to its
contractors. The State Administrative Manual, section 8602, requires state agencies to
capitalize equipment with a unit value of more than $5,000. As discussed above, the State
Contracting Manual clearly requires state agencies to ensure that all equipment purchased by
contractors using state funds remain the property of the state.

The department may have given away millions of dollars in equipment. The Office of

the Inspector General reviewed the department’s accounting records and invoices submitted
by substance abuse program contractors during fiscal year 2004-05 in an attempt to
determine how much equipment the department has allowed contractors to retain, but
found the department does not capture the information needed to determine that amount.
On invoices submitted to the department, substance abuse program contractors categorize
their costs according to the descriptions contained in the line item budget guide. As
discussed above, the department combines supplies and expendable equipment in the same
section. Accordingly, when contractors report the costs they have incurred in carrying out
substance abuse treatment services, they combine the amounts expended for supplies and
expendable equipment. The Office of the Inspector General was, therefore, unable to
separate the value of the equipment from the value of the supplies in the line item, but the
amount reported by all substance abuse program contractors for this line item in fiscal year
2004-05 was more than $1.1 million. Considering that the department’s current budget guide
has been in effect since October 2002; that the department applies the budget guide to
contracts beyond the substance abuse program; and that in fiscal year 2005-06 alone, the
department processed more than $2.6 billion in contracts, the amount of equipment
relinquished to contractors through this inappropriate provision of the budget guide is likely
substantial.
RECOMMENDATIONS
The Office of the Inspector General recommends that the department
immediately revise its budget guide and all current cost reimbursement
contracts to:
•

Ensure that ownership of all property purchased by contractors with state
funds vests with the state.

•

Require contractors to leave all equipment purchased with state funds as
part of a cost reimbursement contract for use by subsequent contractors or
for the department to otherwise utilize according to its needs.

The Office of the Inspector General also recommends that the department
revise its budget guide to require future contractors to leave all unused
supplies purchased with state funds as part of a cost reimbursement contract
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 15
STATE OF CALIFORNIA

for use by subsequent contractors or for the department to dispose of
according to its needs.
Finally, the Office of the Inspector General is referring the matter relating to
the department’s gift of public funds to contractors to the Office of the
Attorney General for its consideration in recovering equipment the
department improperly gifted to contractors. The Office of the Inspector
General recommends that the department cooperate fully with the Office of
the Attorney General in this matter.
FINDING 4
The Office of the Inspector General found that the department may have failed to
hold a contractor accountable for mishandling confidential inmate information.
In June 2006, the department determined that confidential inmate information related to a
substance abuse treatment program operated by Phoenix Houses of California, Inc. at the
California Substance Abuse Treatment Facility and State Prison at Corcoran had been
improperly discarded in the dumpster of a nearby business. This mishandling of confidential
inmate information may have violated state and federal law. However, the investigative
services unit at the California Substance Abuse Treatment Facility and State Prison at
Corcoran was deficient in investigating the incident, and as a result, the department did not
hold the responsible party accountable for its actions.
Phoenix Houses of California, Inc. operated an in-prison therapeutic community substance
abuse program at the California Substance Abuse Treatment Facility and State Prison at
Corcoran under a contract with the department’s Office of Substance Abuse Programs. The
contract provided for the company to be responsible for developing and providing a
substance abuse treatment program to more than 700 inmates and for facilitating continuing
services for inmates transitioning from the in-prison program to a community-based
program after parole. The term of the contract was from January 1, 2002, through June 30,
2006. Beginning July 1, 2006 the department contracted with another contractor to continue
the substance abuse treatment services at the California Substance Abuse Treatment Facility
and State Prison at Corcoran. Accordingly, Phoenix Houses of California, Inc. wrapped up
its program operations and vacated the premises.

Inmate information was discarded in a dumpster of a local business. On June 23,
2006, the manager of a nearby business called the prison’s associate warden of business
services to complain that multiple items belonging to the prison had been placed inside that
business’s dumpster. The associate warden dispatched an employee to the business to collect
the items discovered in the dumpster. The employee retrieved several boxes of paperwork
belonging to Phoenix Houses of California, Inc., and it was determined that the documents
related to the former contractor’s operation of its in-prison substance abuse treatment
program at the prison.

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 16
STATE OF CALIFORNIA

According to the investigation report by the prison’s investigative services unit, among the
items found in the dumpster were the following documents:
•

An inmate roster for a facility at the prison that housed inmates participating in
the substance abuse programs. The roster included inmate names, identification
numbers, housing assignments, ethnicity, and birthdates.

•

A report detailing the caseloads assigned to treatment counselors who had been
employed by Phoenix Houses of California, Inc.

•

A report showing release dates for participants in the prison’s substance abuse
treatment program. The report included inmate names, identification numbers,
housing assignments, and inmate arrival and release dates.

Federal and state law protects inmate information from disclosure. The United States
Code, Title 42 section 290 (dd-2) provides as follows:

Records of the identity, diagnosis, prognosis, or treatment of any patient which are maintained in
connection with the performance of any program or activity relating to substance abuse education,
prevention, training, treatment, rehabilitation, or research, which is conducted, regulated, or directly
or indirectly assisted by any department or agency of the United States shall … be confidential and
be disclosed only for [authorized circumstances].
The section also provides as follows:
Any person who violates any provision of this section or any regulation issued pursuant to this
section shall be [subject to a fine].
State law also prohibits the release of such information. Specifically, Government Code
section 11019.9 requires state departments to enact and maintain a privacy policy that,
among other things, ensures that personally identifiable information is obtained only through
lawful means, and provides that personal data may not be disclosed, made available, or
otherwise used for purposes other than those specified, except with the consent of the
subject of the data, or as authorized by law or regulation. In addition, Civil Code section
1798.24 provides that “no agency may disclose personal information in a manner that would
link the information disclosed to the individual to whom it pertains.” The department’s
contract with Phoenix Houses of California, Inc. stipulated that both of these provisions
applied to Phoenix Houses of California, Inc. in its operation of the in-prison substance
abuse treatment program.
Because the information the department found in the dumpster contained personal
information related to inmates, including names, identification numbers, ethnicity,
birthdates, and release dates, as well as information that linked the inmates to a substance
abuse treatment program, its mishandling appears to have violated the federal and state laws
cited above.

The investigative services unit prematurely closed its investigation. The investigation
conducted by the prison’s investigative services unit was inadequate, thereby precluding the
BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 17
STATE OF CALIFORNIA

department from completing the proper legal analysis needed to determine who was
responsible for the improper disposal of confidential inmate information. The investigative
services unit interviewed several parties, including a representative of Phoenix Houses of
California, Inc., the manager of the local business where the information was found, and a
representative of a mobile shredding company that Phoenix Houses of California, Inc. had
hired to dispose of papers from its operations at the prison. Because all the parties denied
involvement in the improper disposal of the confidential information, and because the
investigative services unit was unable to identify any witnesses to the improper dumping, it
concluded it could not determine who was responsible, closed its investigation, and
destroyed the items retrieved from the dumpster.
As the administrator of the department’s substance abuse treatment programs, the Office of
Substance Abuse Programs has a responsibility to ensure that contractors adhere to the
terms of the contract. To its credit, the department has included in its substance abuse
treatment contracts a provision requiring contractors to protect confidential information
against unauthorized use or disclosure. Therefore, when a breach of confidential
information by a contractor comes to the department’s attention, it has a duty to respond.
In this instance, however, the investigative services unit’s response was inadequate. It failed
to develop the information needed to allow the department to make appropriate factual and
legal conclusions as to who was responsible for the improper dumping of the confidential
inmate information, and to then hold the responsible party accountable for its actions. The
department’s contracts with its substance abuse treatment providers, as well as state and
federal law, hold the providers responsible for the proper safeguarding of inmate
information. Therefore, if the department determined through a properly completed
investigation that Phoenix Houses of California, Inc. was responsible for the improper
disposal of confidential information, the department could hold the company accountable
for its actions.
RECOMMENDATIONS
The Office of the Inspector General recommends that the investigative
services unit at the California Substance Abuse Treatment Facility and State
Prison at Corcoran reconsider its decision to close its investigation related to
the improper disposition of confidential inmate information. In reconsidering
its decision, the investigative services unit should consider the pertinent
federal, state, and contractual criteria that require Phoenix Houses of
California, Inc. to ensure that confidential information is properly
safeguarded.
The Office of the Inspector General also recommends that if the investigative
services unit concludes that Phoenix Houses of California, Inc. did not
properly safeguard confidential inmate information, the department should:
•

Pursue any available legal remedies for violations of federal and state laws.

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 18
STATE OF CALIFORNIA

•

Officially admonish Phoenix Houses of California, Inc. for its failure to
safeguard confidential inmate information so that the department can
consider the actions of Phoenix Houses of California, Inc. in future
contracting considerations.

In addition, the Office of Substance Abuse Programs should make certain
that Phoenix Houses of California, Inc. takes corrective action to ensure that
confidential inmate information it possesses as part of its current or future
substance abuse treatment contracts is adequately safeguarded.
If the Office of Substance Abuse Programs determines that Phoenix Houses
of California, Inc. has not taken appropriate corrective actions, and therefore
cannot properly safeguard confidential inmate information, the department
should cancel its substance abuse treatment contracts with Phoenix Houses
of California, Inc. for cause.

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 19
STATE OF CALIFORNIA

RESPONSE OF THE CALIFORNIA DEPARTMENT OF
CORRECTIONS AND REHABILITATION

BUREAU OF AUDITS AND INVESTIGATIONS
OFFICE OF THE INSPECTOR GENERAL

PAGE 20
STATE OF CALIFORNIA