Performance audit, Arizona State Lottery Commission

              State of Arizona
Office
of the
Auditor General
PERFORMANCE AUDIT
Report to the Arizona Legislature
By Douglas R. Norton
Auditor General
ARIZONA
STATE LOTTERY
COMMISSION
October 1997
Report # 97-15
2910 NORTH 44th STREET • SUITE 410 • PHOENIX, ARIZONA 85018 • (602) 553-0333 • FAX (602) 553-0051
DOUGLAS R. NORTON, CPA
AUDITOR GENERAL
DEBRA K. DAVENPORT, CPA
DEPUTY AUDITOR GENERAL
STATE OF ARIZONA
OFFICE OF THE
AUDITOR GENERAL
October 10, 1997
Members of the Arizona Legislature
The Honorable Jane Dee Hull, Governor
Mr. Jody Spicola, Executive Director
Arizona State Lottery Commission
Transmitted herewith is a report of the Auditor General, A Performance Audit of the Arizona State
Lottery Commission. This report is in response to a May 29, 1995, resolution of the Joint Legislative
Audit Committee. The performance audit was conducted as part of the Sunset review set forth in A.R.S.
§§41-2951 through 41-2957.
The report addresses the need for the Lottery to increase ticket sales and to improve management of its
retail network. Arizona’s Lottery sales rank among the lowest in the nation on a per capita basis.
Turnover of Lottery directors, failure to update on-line games, and poor use of the sales staff have
contributed to the low sales. In addition, the Lottery could do a better job of managing its retail network,
thus reducing its costs and increasing revenues. For instance, the Lottery should do more to collect
amounts owed by retailers for tickets sold. It should also enforce its minimum sales requirements, and
stop paying the costs of maintaining outlets that do not generate enough revenue to justify the expense.
The report also addresses the need to improve the Lottery’s protection of cash on hand and other state
assets, and to correct weaknesses in the security of its computer system.
As outlined in its response, the Arizona State Lottery Commission agrees with all but 1 of the 18 findings
and recommendations, and has stated that the recommendations will be implemented. The Lottery does
not agree with, and will not implement, 1 recommendation relating to computer security procedures.
My staff and I will be pleased to discuss or clarify items in the report.
This report will be released to the public on October 14, 1997.
Sincerely,
Douglas R. Norton
Auditor General
Enclosure
i
SUMMARY
The Office of the Auditor General has conducted a performance audit and Sunset review
of the Arizona State Lottery Commission (Lottery). The audit was conducted in response
to a May 29, 1995, resolution of the Joint Legislative Audit Committee and under the
authority vested in the Auditor General by Arizona Revised Statutes (A.R.S.) §§41-2951
through 41-2957.
The purpose of the Arizona Lottery, which Arizona voters established by an initiative pe-tition
in 1980, is “to produce the maximum amount of net revenue” for the State of Ari-zona.
The Lottery, overseen by a five-member commission appointed by the Governor,
generates revenues by selling state-sanctioned games of chance in the form of both on-line
computerized games and instant ticket games. Since its inception, the Lottery has returned
approximately $1 billion to the State, which has been used for a variety of programs.
Poor Lottery Sales
Limit Returns to State
(See pages 7 through 16)
The Lottery should take action to increase sales that currently rank among the lowest in
the nation on a per capita basis. As a result of low sales, less money is generated for state
programs, and Lottery sales have been flat for a number of years. In fiscal year 1996, the
Arizona Lottery ranked 35th out of 38 state lotteries in per capita sales. When compared
with 8 other states having populations similar to Arizona’s, the Lottery ranked lowest in
both per capita sales and total sales.
A number of factors contribute to the Lottery’s poor overall sales. First, Lottery manage-ment’s
constant turnover has resulted in a lack of continuity and effective long-term stra-tegic
planning. The Lottery has operated under five different Executive Directors in the
last four years, and has also had high turnover in other key management positions. In ad-dition,
the Lottery has not efficiently planned, promoted, and updated its games. For ex-ample,
the Lottery has not updated important on-line games, such as Lotto, despite de-creasing
sales. Further, the Lottery has done a poor job of planning for the production and
scheduling of instant ticket games, and, as a result, has not only lost sales but has wasted
money by printing and then paying to destroy excess tickets. Finally, the Lottery makes
poor use of its sales staff, who spend only 10 percent of their time in direct sales activities,
while 45 percent of their time is spent simply delivering tickets.
ii
To increase sales, the Lottery should improve its management practices. The Lottery could
generate higher sales by addressing problems with its current games and by using tech-nology
and advertising techniques known to increase sales in a short period of time. Fur-ther,
the Lottery should incorporate sound planning and other innovative techniques that
will allow it to operate more effectively. Finally, the Lottery should implement retailer in-centive
programs that are directly tied to increased sales.
Lottery Poorly Manages
Its Retail Network
(See pages 17 through 21)
The Lottery poorly manages its retail network. Currently, the Lottery depends on a net-work
of approximately 2,500 retailers to sell Lottery tickets. While many of these retailers
generate acceptable levels of sales for the Lottery, some do not. In fact, over 25 percent of
Lottery retailers fail to meet the Lottery’s minimum ticket sales standards. The Lottery in-curs
phone line, sales staff, and other operational costs for all its retailers, including those
who fail to meet minimum sales requirements. Further, these retailers use some of the
Lottery’s limited supply of on-line ticket machines, which in the future may be needed for
other retailers with higher sales potential as those retail chains expand.
Additionally, the Lottery has failed to collect monies some retailers owe for tickets sold. As
of March 1997, 266 retailers owed the Lottery a combined total of more than $800,000. In
fact, 14 retailers owed more than $10,000 each, including 1 owing $32,000 and another
owing $64,000. As of March 1997, over 100 retailers had 3 or more instances in which they
failed to pay the Lottery for tickets sold. However, none of these retailers had their licenses
revoked until April 1997 when, during the course of this audit, the Lottery, for the first
time, began collection efforts.
The Lottery should incorporate better management practices for its retail network. First,
the Lottery should enforce its administrative rules requiring retailers to meet minimum
sales levels for on-line and instant ticket sales. The Lottery should also better enforce a
policy of canceling the licenses of retailers who have insufficient monies to pay for Lottery
tickets. Further, the Lottery should continue to collect amounts owed for tickets by first
notifying nonpaying retailers that their licenses will be revoked if they fail to pay; second,
referring retailers who continue not to pay their bills to collection agencies; and, finally,
requesting the Department of Revenue to intercept tax refunds owed to retailers who owe
the Lottery money for tickets. Additionally, the Lottery should conduct routine credit
checks of retailers as part of its licensing process. The Lottery should develop guidelines
for credit checks, including actions to take when retailers are poor credit risks, such as re-quiring
a bond.
iii
Lottery Does Not Adequately
Protect Cash on Hand and
Other State Assets
(See pages 23 through 28)
The Lottery lacks adequate managerial and procedural controls to protect state assets
against potential fraud, waste, or abuse. Specifically, the Lottery fails to protect cash,
prizes, and inventory. For example, some employees have unlimited access to cash draw-ers
and vaults, making theft possible and difficult to detect. Further, its prize and promo-tional
item inventory records are inaccurate, and Lottery staff have distributed game
prizes to retailers and others in violation of statutory provisions governing promotional
items.
Furthermore, the Lottery does not ensure that advertising money is effectively spent. The
Lottery pays approximately $8 million annually to an advertising firm that acts as the
principal advertising and marketing planner for Lottery games; however, the Lottery does
not provide sufficient oversight of the contract.
The Lottery should correct several factors that contribute to its poor internal control envi-ronment.
The Lottery should review its management of cash, vaults, and inventories to
properly safeguard against theft. Further, the Lottery should review the management of
its revolving fund and conduct more frequent reconciliations. Additionally, the Lottery
needs to increase employee training to ensure that employees are properly trained. The
Lottery also needs written policies and procedures to guide its employees in the perform-ance
of their duties relating to cash-handling and inventory management. Finally, the
Lottery should better use its internal audit unit to conduct more audits. Such audits
should examine adherence to policies and procedures, internal control compliance, and
reviewing Lottery contracts and payments to vendors.
Significant Weaknesses
Exist in Lottery
Computer System
(See pages 29 through 32)
The Lottery computer system contains significant weaknesses that may compromise the
system and adversely affect the Lottery’s ability to operate. Despite the system’s impor-tance
to Lottery operations, it lacks adequate security and does not have sufficient backup
capabilities and disaster recovery planning. Some Lottery staff have inappropriate access
to the system, which allows them to access and potentially alter or divulge important con-fidential
data. Further, the Lottery’s computer system does not have a backup processor.
iv
Should a disruption occur, the Lottery would be unable to continue operations, such as
instant ticket validations or on-line game sales, for days or even weeks. Additionally, a
disruption would disable the entire Powerball game, adversely impacting 20 participating
states and thousands of players and leaving the Lottery vulnerable to lawsuits. Finally, the
Lottery relies on an untested and outdated disaster recovery plan, which makes its ability
to continue operations in case of a disaster (such as a fire or acts of negligence) question-able.
v
Table of Contents
Page
Introduction and Background............................................................. 1
Finding I: Poor Lottery Sales
Limit Monies Available
for State Programs ........................................................................... 7
Lottery Sales Poor
Compared to Other States.......................................................................................... 7
A Number of Factors Contribute
to Poor Overall Lottery Sales..................................................................................... 9
Lottery Should Improve
Practices to Increase Sales........................................................................................... 12
Recommendations....................................................................................................... 16
Finding II: Lottery Poorly Manages
Its Retail Network.............................................................................. 17
Background................................................................................................................... 17
Lottery Has Not Collected
Money from Retailers Who
Fail to Pay Their Bills................................................................................................... 17
Lottery Has Failed to Ensure That
Retailer Distribution System
Is Cost-Effective ........................................................................................................... 19
Recommendations....................................................................................................... 21
Finding III: Lottery Does Not Adequately
Protect Cash on Hand and Other
State Assets....................................................................................... 23
Lottery Fails to Sufficiently
Protect State Assets...................................................................................................... 23
vi
Table of Contents (cont’d)
Page
Finding III: (con’t)
Lottery Should Correct Several
Factors That Contribute to a Poor
Internal Control Environment................................................................................... 26
Recommendations....................................................................................................... 28
Finding IV: Significant Weaknesses Exist
in Lottery Computer System........................................................... 29
Background................................................................................................................... 29
Lottery Computer System
Lacks Adequate Security............................................................................................ 29
Computer System Lacks Adequate
Backup Capabilities and
Disaster Recovery Planning....................................................................................... 31
Recommendations....................................................................................................... 32
Sunset Factors....................................................................................... 33
Agency Response
vii
Table of Contents (concl’d)
Page
Tables and Figure
Table 1 Arizona State Lottery Commission
State Programs Receiving Lottery Revenues
Years Ended June 30, 1982 through 1996
(Unaudited) ................................................................................... 2
Table 2 Arizona State Lottery Commission
Income Statement
Years Ended June 30, 1994 through June 30, 1996
(Based on Independent Auditor’s Report)............................... 4
Table 3 State Lotteries
Ranked by Per Capita Sales
Year Ended June 30, 1996............................................................ 9
Figure 1 Arizona State Lottery Commission
Lottery Sales
Years Ended June 30, 1985 through 1997
(Unaudited) ................................................................................... 8
viii
(This Page Intentionally Left Blank)
1
INTRODUCTION AND BACKGROUND
The Office of the Auditor General has conducted a performance audit and Sunset review
of the Arizona State Lottery Commission. The audit was conducted in response to a May
29, 1995, resolution of the Joint Legislative Audit Committee and under the authority
vested in the Auditor General by Arizona Revised Statutes (A.R.S.) §§41-2951 through 41-
2957.
Lottery History and
General Information
Arizona citizens established the Arizona Lottery in 1980 through an initiative petition in
the general election. The purpose of the Lottery is “to produce the maximum amount of
net revenue” for the State of Arizona. Since its inception, nearly $1 billion in prizes has
been awarded to Lottery players and approximately $1 billion has been returned to the
State, which has been used for a number of programs. Arizona uses a complicated funding
distribution formula to allocate monies to 12 programs. Table 1 (see page 2) shows how
the State has distributed Lottery monies from fiscal years 1982 through 1996.
The Lottery offers state-sanctioned games of chance, which are delivered in both an on-line
and instant ticket format.
n On-Line Games—Lotto, Powerball, and Fantasy 5 are called on-line games because
retailers use computer terminals to record the numbers players select. Players attempt
to select numbers that will match numbers drawn biweekly or weekly to win cash or
prizes. For example, players attempt to match 6 of 42 numbers to win the Lotto jackpot.
The Powerball game is operated jointly by Arizona and 20 other states. On-line games
historically account for a minimum of 65 to 75 percent of total Lottery sales. However,
as shown in Table 2 (page 4), they are currently experiencing declining sales.
n Instant Ticket Games—Instant ticket games do not require computer terminals and
offer immediate results to players. Players simply scratch off a protective latex cover-ing
to determine if they have won cash or prizes. Win for Life, where players attempt to
match numbers to win $1,000 per month for life, is an example of a current Lottery in-stant
ticket game. The Lottery usually introduces at least 20 new instant ticket games
per year. Instant ticket games generate lower revenues than on-line games but their
share of total revenues has grown. Statute also requires the Lottery to introduce two
special annual instant ticket games to generate revenues to be used by the Arizona De-partment
of Commerce for economic development.
2
Table 1
Arizona State Lottery Commission
State Programs Receiving Lottery Revenues
Years Ended June 30, 1982 through 1996
(Unaudited)
Programs
Total Statutory Distributions
in Millions of Dollars
State General Fund—Appropriated for a variety of purposes including
education, public health, public safety, general government, inspection,
regulation, and natural resources. $ 466
Local Transportation Assistance Fund—Used by Arizona cities and
towns for a variety of transportation-related purposes, including mass
transit. Up to 10 percent of these monies can be used for sociocultural
programs if matched by private monies. 328
State Heritage Fund—Used by Arizona State Parks and the Arizona
Game and Fish Commission to pay for trail and park maintenance,
land acquisition, and educational programs. 111
County Assistance Fund—Used by the counties for a variety of pro-grams
such as law enforcement, education, and health. 76
Economic Development Fund—The Arizona Department of Com-merce
uses these monies to attract new businesses into the State. 23
Clean Air Fund 1—Created in 1996, this fund will be used by the Ari-zona
Department of Commerce for a variety of purposes, including
grants promoting the use of alternative fuels and High Occupancy Ve-hicle
(HOV) signs on federal and state roads. None
Healthy Arizona Programs 1—Proposition 203, passed in the 1996
general election, created Lottery funding for the following programs:
n Healthy Families Pilot Program
n Arizona Area Health Education System
n Teenage pregnancy prevention programs
n Health Start Pilot Program
n Disease Control Research Fund
n Women, Infants, and Children Food Program   None
Total $1,004
1 JLBC forecasts that the Clean Air Fund will receive about $7.5 million in fiscal year 1998, but projects
Lottery sales will be too low to provide any funding to the Healthy Arizona programs that year.
Source: Arizona State Lottery Commission.
3
Retailers, such as grocery and convenience stores, must obtain a license from the Lottery in
order to sell Lottery tickets. Currently, there are approximately 2,500 Lottery vendors, who
receive a commission for selling tickets. For fiscal year 1996, retailers received $15.5 million
in commissions. Legislation passed in 1997 increased the amount of retailer commissions
from 6 percent of ticket sales to a minimum of 6.5 percent and a maximum of 7 percent.
The Lottery has not yet determined the requirements retailers must meet to receive a 7
percent commission.
Staffing and
Organization
A.R.S. §5-502 establishes the Arizona State Lottery Commission, which oversees the Lot-tery.
The Commission consists of five members, appointed by the Governor, who meet
monthly to set policy and transact business to guide efforts toward maximizing Lottery
revenues. An Executive Director appointed by the Governor administers Lottery opera-tions.
The Director also serves as the Commission’s secretary and executive officer.
In fiscal year 1996, the Lottery employed 121 full-time employees in Phoenix and Tucson
offices working in 4 divisions: Administrative, Management Information Systems, Sales
and Marketing, and Security. Each division has a Director.
Budget Information
The Lottery receives monies annually from the State Lottery Fund. The Lottery is re-stricted
by statute to spending no more than 18.5 percent of its revenues on administrative
expenses, and no more than 4 percent of its revenues on advertising. Table 2 (see page 4)
summarizes the Commission’s actual revenues and expenditures for fiscal years 1994,
1995, and 1996.
Audit History
The Office of the Auditor General has conducted several audits of the Lottery in the past.
A performance audit was last conducted in February 1987 as part of a Sunset review of the
Lottery (Auditor General Report 87-3). The audit found that the Lottery’s administrative
budget needed to be reduced and recommended stronger budgetary oversight. The Leg-islature
has since reduced the Lottery’s administrative budget from 25 percent to 18.5 per-cent
of total revenues. The audit also recommended that the Lottery improve its contract
selection process.
4
Table 2
Arizona Lottery Commission
Income Statement
Years Ended June 30, 1994 through June 30, 1996
(Based on Independent Auditor’s Report)
1994 1995 1996
Revenues:
Lottery ticket sales:
Instant $ 57,514,820 $ 69,724,511 $ 82,860,334
Economic Development 5,706,804 7,488,838 4,925,255
Powerball (introduced April 1997) 19,180,539 92,889,772 77,772,697
Lotto 142,286,940 97,075,149 75,853,040
Fantasy 5 24,036,667 18,810,756 17,424,824
Total lottery ticket sales 248,725,770 285,989,026 258,836,150
Lottery prize payouts:
Instant 30,327,779 40,953,795 46,684,497
Economic Development 2,797,408 4,883,228 2,712,285
Powerball 9,590,270 46,096,959 38,251,164
Lotto 68,243,281 48,226,394 37,622,309
Fantasy 5 11,472,452 9,288,743 8,173,460
Total lottery prize payouts 122,431,190 149,449,119 133,443,715
Net lottery ticket sales 126,294,580 136,539,907 125,392,435
Retail license fees 8,900 6,875 6,800
Other revenues    388,143    464,925   1,130,570
Total revenues 126,691,623 137,011,707 126,529,805
Expenses:
Retailers’ commissions 15,372,198 17,217,701 15,551,375
Advertising and promotion 10,485,453 10,955,481 9,888,283
On-line system expenses 7,399,794 8,175,629 4,793,347
Tickets purchased 1,769,122 1,771,747 2,460,514
Personnel 4,071,522 4,134,350 3,993,479
Contract services 135,730 206,851 435,247
Other expenses   1,848,564   2,205,016   2,628,771
Total expenses 41,082,383 44,666,775 39,751,016
Net income before transfers to other State of
Arizona funds 85,609,240 92,344,932 86,778,789
Transfers to other State of Arizona funds (82,420,376) (92,544,165) (87,283,086)
Increase (Decrease) in retained earnings 3,188,864 (199,233) (504,297)
Retained earnings, beginning of year 5,078,449 8,267,313 8,068,080
Retained earnings, end of year $ 8,267,313 $ 8,068,080 $ 7,563,783
Source: Arizona Lottery Commission financial statements audited by Deloitte & Touche LLP.
5
Further audit work determined that contracting continues to be a problem at the Lottery.
Two special audits by the Auditor General have examined Lottery contracts and con-tracting
practices. First, in 1993, a special audit examined three contract awards. The audit
determined that the Lottery failed to competitively bid a contract for over $10,000 in viola-tion
of A.R.S. §§41-2533 and 41-2534, questioned the appropriateness of another contract
award, and found that a consultant’s travel costs were being reimbursed without follow-ing
state guidelines regarding allowable daily expenses. In 1995, another special audit was
conducted to determine whether payments made by the Lottery to its contracted adver-tising
firm were being made in accordance with statute and the specific terms of the con-tract.
The audit determined that payments to the vendor did not comply with statute,
travel cost reimbursements paid to the vendor exceeded state allowances, the contract was
not properly amended, and the Lottery’s internal audit staff did not play an active role in
administering the contract. The current audit determined that the Lottery has not rectified
some of the issues identified in the 1995 audit (see Finding I, pages 7 through 16).
Audit Scope
and Methodology
Audit work focused on the Lottery Commission’s ability to fulfill its statutory role of
maximizing revenues. As such, the audit examined the Lottery’s business practices and
overall business environment, including its financial and computer internal control sys-tems,
its relationship with Lottery retailers, and its overall approach to increasing Lottery
revenues. The audit team used a combination of methods to conduct the review, includ-ing:
n Conducting a comprehensive internal control review of Lottery financial and computer
structures, including the evaluation of policies and procedures and test work of Lot-tery
expenditures, reconciliations, prize distribution, and inventory;
n Attending four Lottery Commission meetings and reviewing Commission meeting
minutes from 1994 through 1996;
n Interviewing representatives from selected Lottery retailers, such as Bashas’, Safeway,
and Circle K.
n Interviewing 8 vendors who provide on-line and/or instant ticket services in other
states and countries;
n Reviewing the Lottery’s process for planning and implementing games including rele-vant
documentation;
6
n Reviewing the Lottery’s 3 major contracts including its advertising, instant ticket, and
on-line procurements;
n Contacting 21 states operating lotteries as well as national lottery organizations such as
the National Association of State and Provincial Lotteries (NASPL);
n Conducting a review of literature, including journal articles and reports from other
states, such as national lottery advertising, sales, retailer distribution, and financial
comparison data located in Lafleur’s 1996 World Lottery Almanac.
As a result of this audit work, findings and recommendations are presented in four areas:
n The Lottery could implement better practices to increase sales;
n The Lottery does not use sound practices in its relationships with Lottery retailers,
which hinders its ability to maximize sales;
n Lottery financial internal controls are weak, subjecting the State to an increased likeli-hood
of fraud, waste, and abuse; and
n The Lottery’s EDP internal control environment has flaws that could potentially result
in millions of dollars lost in revenues in the event of a disaster.
The audit was conducted in accordance with government auditing standards.
The Auditor General and staff express appreciation to the Arizona Lottery Commissioners,
the Lottery Executive Director, and Lottery staff for their cooperation and assistance
throughout the audit.
7
FINDING I
POOR LOTTERY SALES LIMIT MONIES
AVAILABLE FOR STATE PROGRAMS
The Arizona Lottery should take action to increase sales that currently rank among the
lowest in the nation on a per capita basis. Due to low revenues, less money is generated
for state programs. Many factors contribute to poor Lottery sales, including high man-agement
turnover, poorly planned or promoted games, and inadequate use of staff. Addi-tionally,
other issues affect the Lottery’s sales, such as competition from Indian gaming,
problems with a previous on-line vendor, and the federal Americans with Disabilities Act
(ADA) inspection requirements. The Lottery should adopt sound business practices and
implement techniques being used by other states or recommended by industry experts to
better maximize revenues.
Lottery Sales Poor
Compared to Other States
The Arizona Lottery does not appear to be effectively meeting its statutory charge of
maximizing revenues. Lottery sales, which have never been high compared to other states,
remain stagnant, resulting in less money for state programs. As a result of the Lottery’s
poor performance, the State may not obtain the revenues necessary to fund certain pro-grams.
Poor Lottery sales limit returns to the State—As illustrated in Figure 1 (see page 8), Ari-zona
Lottery sales have remained fairly constant since fiscal year 1989, limiting the
amount of monies available for state programs. From fiscal year 1989 through fiscal year
1996, Lottery sales averaged approximately $259 million annually with a high of $288 mil-lion
(1990) and a low of $230 million (1991). For fiscal year 1997, the Lottery generated ap-proximately
$250 million in sales. Further, Lottery projections presented to the 1997 Leg-islature
forecast that fiscal year 1998 sales could be as low as $214 million. As a result of
declining sales, the Joint Legislative Budget Committee (JLBC) expects that the Healthy
Arizona and Mass Transit programs will not receive funding in fiscal year 1998 since they
have a lower statutory priority than other programs receiving Lottery monies.
8
Figure 1
Arizona State Lottery Commission
Lottery Sales
Years Ended June 30, 1985 through 1997
(Unaudited)
Source: Arizona State Lottery Commission.
Arizona Lottery ranks near the bottom in per capita sales—The Lottery is a poor per-former
compared to other state lotteries. In fiscal year 1996, the Lottery ranked 35th out of
38 state lotteries in per capita sales. During that year, Arizona had per capita sales of $63,
compared to the national average of $159 and a national high of $505 (Massachusetts).
When compared with 8 other states having populations similar in size to Arizona’s
(Washington, Colorado, Oregon, Wisconsin, Minnesota, Kentucky, Maryland, and Con-necticut),
the Lottery ranked lowest in per capita sales in fiscal year 1996. Table 3 (see page
9) ranks U.S. lotteries based on per capita sales in 1996.
$250
$230
$288
$0
$50
$100
$150
$200
$250
$300
$350
'85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97
Fiscal Year
9
Table 3
State Lotteries
Ranked by Per Capita Sales
Year Ended June 30, 1996
State
Per Capita
Sales State
Per Capita
Sales
1. Massachusetts $505 20. New Hampshire $128
2. Rhode Island 455 21. Vermont 128
3. District of Columbia 352 22. Maine 122
4. South Dakota 285 23. West Virginia 117
5. Delaware 269 24. Indiana 113
6. Georgia 245 25. Wisconsin 93
7. Oregon 226 26. Colorado 88
8. Maryland 218 27. Minnesota 85
9. Connecticut 215 28. Idaho 83
10. Ohio 214 29. Missouri 81
11. New Jersey 206 30. Kansas 73
12. New York 199 31. Washington 72
13. Texas 180 32. California 72
14. Michigan 152 33. Iowa 68
15. Florida 150 34. Louisiana 67
16. Kentucky 141 35. Arizona 63
17. Virginia 139 36. Nebraska 50
18. Pennsylvania 139 37. Montana 40
19. Illinois 138 38. New Mexico 18
Source: Lafleur’s 1996 World Lottery Almanac. Boyds, MD: TLF Publications, 1996.
A Number of Factors Contribute
to Poor Overall Lottery Sales
Several factors contribute to poor Lottery sales. First, constant turnover of Lottery man-agement
during the past five years has resulted in a lack of continuity, which in turn has
prevented the Lottery from conducting meaningful long-term strategic planning and from
setting and reaching measurable goals. Second, the Lottery’s attempt to plan, promote,
and update its games have been hampered by inefficiency and, in some cases, wasted re-sources.
Further, the Lottery poorly utilizes its sales force. Finally, sales are affected by
10
some factors outside of the Lottery’s direct control, such as contractual problems with the
Lottery’s former on-line vendor and competition from Indian gaming.
Turnover in executive management hinders sales performance—Frequent changes in the
Lottery’s leadership have prevented long-term planning and have had an adverse impact
on Lottery sales. The Arizona Lottery has operated under five different Executive Direc-tors
in the last four years. Additionally, between August 1996 and April 1997, the Lottery
also experienced turnover in all four of the Division Director positions and four primary
mid-level management spots that directly affect or support sales, including the Directors
of Administration, Management Information Systems, Security, and Sales and Marketing,
as well as the Attorney General Representative and the Promotions, Advertising, and
Corporate Marketing Managers.
Lottery practices contribute to poor Lottery sales performance—This turnover has led to
inadequate planning and promotion of both on-line and instant games which has, in turn,
resulted in poor sales, and in some cases, wasted resources. Additionally, Lottery sales
personnel are not being used efficiently. The following are examples of problems with the
Lottery’s business practices:
n Stale games not updated—On-line game sales, which traditionally generate a major-ity
of the Lottery’s sales, are eroding. According to Lottery officials, these games are
old and no longer generate player interest. Experts suggest that on-line games should
be reexamined and enhanced every 18 months. However, the Lottery has not made
any significant changes to the Lotto game since 1989. Further, the Lottery has not made
any changes to the Fantasy Five since its inception in 1991. As a result, sales are de-creasing.
In fiscal year 1996, Lotto, Fantasy 5, and Powerball on-line games generated
approximately $171 million in sales, as opposed to an average of $200 million per year
over the previous 6 years and a high of $239 million in 1990. Despite decreasing sales,
on-line games still accounted for 58 percent of total Lottery sales in fiscal year 1997.
Introducing new on-line games may not result in an overall increase in on-line sales
because, historically, new on-line games gain sales at the expense of older on-line
games. For example, Powerball generated approximately $19 million in sales when it
was introduced in 1994. However, Lotto and Fantasy 5 experienced over a $26 million
decrease in sales that same year. Therefore, overall on-line sales actually decreased by
$7 million that year. Consequently, enhancing older, established games may have a
greater impact on sales than simply introducing new games.
n Problems with instant ticket games—Lottery management of instant ticket games
displays its own set of problems. Though many instant games have been successful,
the Lottery has generally done a poor job of planning for instant games’ production
and scheduling. The Lottery orders too many tickets and runs games for excessive pe-riods
of time. For example, in fiscal year 1995, the Lottery’s instant games ran for an
11
average of 41 weeks. Some experts believe sales reach a point of diminishing return
around 19 weeks or less. As a result of poor planning, 51 million tickets went unsold
over a 2-year period. These tickets were destroyed, representing a loss of more than $1
million in printing costs alone, and there were additional costs associated with dis-posal.
n Poorly planned games—Along with its failure to address general problems with both
on-line and instant ticket games that affect sales, the Lottery has done a poor job of
planning and promoting some specific games. For one instant ticket game, the Lottery
spent $30,000 in promotions to generate only $52,000 in sales, and had $154,000 in prize
inventory left at the end of the game. In another instance, the Lottery worked seven
months and spent over $15,000 for an on-line game that was eventually canceled be-cause
of planning problems.
n Sales representatives could be better used—Finally, Lottery sales representatives
do not spend enough time selling the Lottery’s products. For example, a Lottery re-view
found that sales representatives spend only 10 percent of their time in direct
sales, such as introducing or selling new games and recruiting new accounts. In fact, at
least 45 percent of their time is spent simply delivering tickets and additional time is
spent inspecting retailers for compliance with federal Americans with Disabilities Act
requirements.1 Retailers interviewed believed that Lottery sales staff do not spend
adequate time selling its products. One retailer stated that the Lottery needs to get their
sales staff “out of the delivery business and into the sales business.”
Other factors contribute to poor sales—Other factors also influence poor Lottery sales.
Most notably, in 1996, the Lottery’s on-line vendor defaulted on its contract resulting in
lost sales and damaged relations with players and retailers. Between November 1995 and
January 1996, the vendor’s computer software was unable to tally how much each store
owed for tickets sold. The vendor eventually agreed, through a negotiated settlement with
the Lottery, to pay the State approximately $11 million for damages. Additionally, the
Lottery competes for dollars with other gaming enterprises, such as Indian casinos. This
competition is not unique to Arizona, since 21 other lottery states, most of which have
higher per capita sales than Arizona, experience competition from Indian gaming. How-ever,
the State’s compacts with Indian tribes restrict the Lottery’s ability to implement
some types of games, such as Keno or video lottery. Other states, such as Delaware, Ore-gon,
and West Virginia, dramatically increased sales by operating these types of games.
1 In 1996, the Superior Court of Arizona ruled that the Arizona Lottery must inspect all retailers selling
Lottery products for compliance with the federal Americans with Disabilities Act.
12
Lottery Should Improve
Practices to Increase Sales
The Lottery should employ better business practices and innovative sales techniques to
better maximize revenues. The Lottery could generate higher sales by addressing prob-lems
with its current games and by using technology and advertising techniques known
to increase sales in a short period of time. Further, the Lottery should incorporate sound
planning and other innovative techniques that will allow the Lottery to operate more ef-fectively
and, thereby, return more monies to the State. Finally, the Lottery should imple-ment
retailer incentive programs that are tied directly to increased sales.
Changes to games are necessary to increase sales—The Lottery should rejuvenate estab-lished
on-line games to increase sales instead of relying solely on new games that may not
succeed. In addition, the Lottery should add a variety of games to its mix and consider
running them for shorter periods. Further, the Lottery should consider offering games
with different prices and prize structures that ensure more winners and repeat players in-stead
of relying solely on higher prize payouts to increase sales.
n Revamp on-line games—Many methods are readily available to stimulate sagging
on-line games. Common tactics include changing the game matrix (for example,
changing from 45 numbers to 41 numbers), adding smaller prizes with better chances
for winning, running short-term promotions, holding second chance drawings, and
emphasizing local winners to generate game interest. For example, the Connecticut
Lottery gives players an extra number for an additional 50 cents on a $1 wager in their
Lotto games.
n Add to the current game mix—Many successful games other state lotteries use have
not been incorporated into Arizona’s game mix. Examples include instant ticket pull-tab
games, where players pull a perforated section on the ticket to determine if they are
a winner; and three- or four-number on-line daily games, where players match three or
four numbers for smaller jackpots. Of eight states with populations similar to Ari-zona’s,
three operate pull-tab games and seven have three- or four-digit games. All of
these states have higher per capita sales than Arizona.
n Consider shorter-term games—Arizona should run its instant ticket games for
shorter periods to minimize losses from poorly performing games. Nationally, lotteries
are releasing their instant ticket games for shorter periods to reduce printing costs and
the waste that results from unsold tickets. For example, the Idaho Lottery now oper-ates
games for 11-week periods and the Indiana Lottery prints only half the tickets per
game that it did in the past.
13
n Use variety in game price and prize structures—Arizona should consider using dif-ferently
priced instant ticket games with varied prize structures in order to generate
better sales. Other states offer a variety of differently priced instant ticket games that
are designed to increase sales and player interest by offering options. For example, 17
other state lotteries operate $5 games, while 16 states have $3 games. Some states have
even offered $10 games. Altering game prize structures can also increase sales. For ex-ample,
prizes for a game can be structured so that there are many lower-level prize
winners instead of only a few players who win the entire jackpot. Experts suggest that
low-level prize winners are likely to reinvest their small winnings back into more lot-tery
tickets. Lottery officials from states using these techniques report that using differ-ently
priced and structured games offers players options, which increases their interest
and, therefore, sales, without increasing the amount of money lottery officials must use
for prizes.
Self-service technology can improve sales—The Lottery should consider using self-service
lottery vending machines, preferred by retailers and players, to increase sales. Represen-tatives
from Bashas’, Safeway, and Circle K, three of the Lottery’s major retailers, informed
auditors that retailers prefer these machines because they do not place a great demand on
staff resources and require only limited floor space. In fact, one estimated that these ma-chines
save retailers as much as 20 percent in labor time. Also, players enjoy these ma-chines
because they can purchase tickets quickly and easily.
Arizona should consider using more Individual Ticket Vending Machines (ITVMs) to in-crease
sales. ITVMs are customer-operated lottery vending machines that hold up to a
dozen games at one time. They lease for approximately $2,400 annually and are proven to
increase sales. For example, the Texas Lottery recently experienced a 43 percent jump in
ticket sales after adding ITVMs, an average incremental increase in sales of $794,000 per
week. The Missouri Lottery installed ITVMs and realized a 62 percent sales increase. Fur-ther,
nearly 30 percent of Kentucky’s and Virginia’s ticket machine networks consisted of
ITVMs, as opposed to only 7 percent in Arizona. Additionally, some states, such as Cali-fornia
and Pennsylvania, use other types of self-service machines similar to ITVMs, such
as in-counter dispensers and kiosks, to increase sales.
Point-of-sales advertising helps to increase sales—In-store advertising in the form of
signs, banners, stickers, and other promotional items helps to increase sales by drawing
customers’ attention to Lottery products while they are in a store. Currently, the Lottery
expends only a minimal amount of its advertising budget for point-of-sale advertising.
However, according to Arizona retailers, lottery tickets are impulse purchase items, so in-store
advertising, such as logos on grocery bags, can have a substantial impact on sales.
Some states focus heavily on in-store advertising to increase sales. Massachusetts, the state
with the highest per capita sales, commits 100 percent of its advertising budget to in-store
advertising. Michigan and West Virginia allocate approximately 25 percent of their adver-tising
budgets to in-store advertising.
14
Management and marketing changes are needed to increase sales—The Lottery could in-crease
sales by adopting better management and marketing techniques. The Lottery
should implement long-term planning models focused on goals that would increase sales.
Additionally, the Lottery should consider alternate methods of instant ticket delivery.
Further, the Lottery could increase sales by using direct mailing and copromotions.
n Effective long-term planning—The importance of long-term planning is widely rec-ognized
because it helps to ensure that goals can be set and worked toward regardless
of turnover and other factors. Arizona should adopt planning models that are focused
on increasing sales. Other state lotteries have adopted planning models that may be of
use to the Arizona Lottery. For instance, the Maryland Lottery has formed an instant
ticket planning committee to develop games. The California Lottery is required to con-duct
demographic studies of lottery players and the effectiveness of lottery communi-cations.
n More production from sales staff—Instead of relying on sales staff to deliver tickets,
the Lottery should examine other approaches that would free staff to increase their
sales time with retailers. Retailers indicated that Lottery sales staff spend too much
time delivering tickets and not enough time selling product. Further, over 70 percent of
other states use a combination of courier and sales staff to deliver tickets. Only eight
other lotteries besides Arizona use sales representatives as their primary way to deliver
tickets. Some states, like Florida and Pennsylvania, have recently required the instant
ticket vendor to deliver tickets to retailers.
n Direct mail promotions—Direct mail allows lotteries to send players and potential
players information at their residences about features such as discounts, promotions,
and new products. Many lotteries use direct mail to increase sales and to gather infor-mation.
For example, the Ohio Lottery annually receives approximately 400,000 survey
responses from residents discussing lottery products. Ohio Lottery officials believe di-rect
mail allows them to reach all types of players. Delaware sends coupons to players
with surveys on the back. Further, Massachusetts, Oregon, and West Virginia use the
mail to offer players one free ticket for every ticket purchased.
n Copromotions—Copromotions can also be used to increase sales. In copromotions,
lotteries and private companies share costs for advertising and promoting lottery
games. Some lotteries use copromotions to offset high advertising costs for Lottery
products. For example, the Ontario Lottery recently ran a successful copromotion in
which McDonald’s bought $2.5 million in tickets as promotions and supplied $1.5 mil-lion
in advertising. Similarly, in 1997, the Illinois Lottery worked with two Las Vegas
hotels (MGM and Caesar’s Palace) to copromote a lottery game.
15
Lottery retailer program should be monitored—The Lottery should monitor the effect of a
recent change in its retailer incentive program, and consider alternatives used in other
states if the current plan does not have the desired effect of increasing sales. In 1997, the
Legislature raised retailer commissions from 6 percent to 6.5 percent as a means of im-proving
its relationship with retailers and thereby, sales. While the increased commission
will probably improve retailers’ satisfaction with the Lottery, evidence suggests it may do
little to boost sales. For example, a representative from a large retail chain states that the
commission would have to match or exceed those of other consumer products, which is as
high as 25 percent, before they would change the way lottery products are marketed in
their stores. Further, in 1996, prior to the increase, Arizona had one of the highest commis-sion
rates of the 38 states operating lotteries, yet it ranked 35th in per capita sales. There-fore,
the Lottery should closely monitor the effect of the change over the next two years. If
the increased commission does not result in increased marketing efforts on the part of the
retailers, or if sales continue to decline, the Lottery should return to the Legislature with a
proposal for a restructured incentive plan. This plan should begin with a lower base
commission rate but provide other incentives tied more closely to sales, such as those used
in other states with higher per capita sales.
n Sales goal bonuses—Many states offer retailers bonuses for reaching sales goals. For
example, Kentucky offers retailers a 5 percent bonus on incremental sales over retail-ers’
annual quota. Colorado, Delaware, Georgia, Idaho, and Oregon all offer bonuses
to retailers for exceeding sales goals.
n Incentive contests—Some states offer bonuses to retailers who win sales incentive
contests. Michigan held a four-month incentive contest awarding cash prizes to retail-ers
with the highest sales increase over the previous year. Kentucky holds quarterly in-centive
contests for instant games. Minnesota holds an annual incentive program tar-geting
premium lottery products.
n Cashing bonuses—States such as California, Colorado, Idaho, Indiana, Kansas, Lou-isiana,
Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, Ohio, South
Dakota, and West Virginia offer cashing bonuses ranging from 1 to 3 percent of the
total dollar amount of winning tickets redeemed by a retailer. Cashing bonuses com-pensate
retailers in these states for taking the time to cash and process winning lottery
tickets.
Lottery is making plans intended to increase sales—The 1998 Lottery Marketing Plan
contains preliminary plans that may increase sales. While the plan lacks specific and clear
objectives and time lines to measure actual performance, it does address the need to reju-
16
venate older on-line games, change the current game mix, and build the player base
through the introduction of new games. However, the success of any plan will be deter-mined
by the Lottery’s improvement in general business methods and appropriate long-term
management.
Recommendations
1. The Lottery should update current on-line games like Lotto and Fantasy 5, instead of
solely relying on new on-line games, in order to boost sales.
2. The Arizona Lottery should implement long-term planning to increase sales and
evaluate actual Lottery performance.
3. The Lottery should consider better utilizing sales staff, including finding ways to better
handle ticket delivery and the Americans with Disabilities Act compliance issues,
which would allow sales staff more time to increase sales.
4. The Lottery should consider utilizing innovative practices proven to increase sales,
such as adding games to its current game mix; shortening the time specific games are
offered; using direct mail, copromotions, and in-store advertising materials; introduc-ing
multiple priced games; and redesigning prize payout structures so that there are
more lower-tier winners and repeat players.
5. The Lottery should consider obtaining additional ITVMs through lease or purchase,
and acquire other technologically advanced equipment.
6. The Lottery should monitor the effect of a recent change in its retailer incentive pro-gram
and be prepared to propose a restructured incentive program to the Legislature if
the current plan does not help to increase sales within two years.
17
FINDING II
LOTTERY POORLY MANAGES
ITS RETAIL NETWORK
The Lottery does not use effective business practices in managing its retailer distribution
system. Similar to private sector wholesalers, the Lottery works with a network of retail
stores to sell lottery tickets to the public. However, the Lottery does not adequately ensure
that its retailers pay for the tickets they sell. Further, the Lottery has failed to remove un-profitable
retailers from its retail network, even though it incurs costs for maintaining
them in the network.
Background
The Lottery’s retailer distribution system is critical to its sales success. The Lottery de-pends
on a network of approximately 2,500 retailers, 100 of which sell only instant tickets,
to sell lottery tickets to the public. These 2,500 retailers include convenience, grocery, and
drug stores; gas stations; and a variety of other small businesses. To become a lottery re-tailer,
a business must obtain a lottery retailer license and pass a criminal background and
financial credit check. In return for selling lottery tickets, a retailer is allowed to keep 6.5
cents of every dollar sold. The Lottery receives most of its portion of ticket revenue from
retailers by weekly collecting monies owed through electronic fund transfers. The Lottery
receives revenue from tickets sold less retailer commissions earned.
Lottery Has Not Collected
Money from Retailers Who
Fail to Pay Their Bills
The Lottery’s efforts to collect money retailers owe have been ineffective. As of February
28, 1997, 266 retailers owed the Lottery a total of more than $800,000 for tickets sold. How-ever,
the Lottery continued to deliver new tickets to these retailers, although its retailer
agreement provides that retailers who fail to pay their bills can be barred from selling ad-ditional
tickets. Further, the Lottery does not use the kinds of collections efforts used by
other state agencies. Finally, in addition to the initial background checks already per-formed,
the Lottery should develop guidelines for conducting routine credit checks and
taking actions, such as requiring a bond from retailers with poor credit, to protect itself
from losses to insolvent retailers.
18
Numerous retailers owe money for tickets sold—Many retailers owe the Lottery money
earned from tickets sold because they have not had sufficient monies in their accounts to
pay for sold tickets. As a result, amounts owed by retailers have been accumulating. As of
February 28, 1997, 266 retailers owed more than $800,000. Fourteen retailers owed more
than $10,000 each, including 2 owing approximately $32,000 and $64,000, respectively.
Retailers who do not pay continue to be allowed to sell—Even though many retailers fail
to pay for the tickets they sell, the Arizona Lottery did nothing to stop them from con-tinuing
to sell tickets until April 1997. As of February 28, 1997, 106 retailers had failed 3 or
more times to have enough money in their bank accounts to pay for the lottery tickets they
sold. In fact, 3 retailers failed to have enough money in their accounts every week for 52
weeks or more. However, none of these retailers had their selling privileges revoked until
April 1997 when, during the course of this audit, the Lottery, for the first time, began ef-forts
to collect debts. As of July 1997, the Lottery had suspended or revoked the licenses of
13 retailers and collected approximately $173,000 in debts owed for tickets sold. The Lot-tery
should better enforce its rule for revoking the licenses of retailers who continually fail
to have sufficient monies in their accounts to pay their bills.
Lottery has not made adequate efforts to collect amounts owed—Even though some re-tailers
owe the Lottery substantial amounts of money for tickets sold, the Lottery does lit-tle
to collect these amounts. For example, until recently, the Lottery failed to send out no-tices
to retailers warning them that their selling privileges might be canceled if they fail to
pay the amounts owed. In addition to sending out warnings, the Lottery could also re-quire
retailers who owe the Lottery money to pay for tickets on delivery until they have
satisfied their debt.
The Lottery also does not use collection methods used by other state agencies. Agencies
such as the Department of Real Estate, the Attorney General’s Office, and the Department
of Building and Fire Safety contract with collections agencies to collect amounts owed to
them. In addition, A.R.S. §42-133 states that any debt owed to a state agency can be subject
to an offset of any tax refund owed. The Lottery could request that the Department of
Revenue intercept individual tax refunds to owners of sole proprietorships or partnerships
whose retail establishments owe debts to the Lottery.
Lottery does not ensure retailers are creditworthy—In addition to collecting amounts
owed, the Lottery should do more to ensure existing retailers are creditworthy. The Lot-tery
currently performs a credit check on retailers only when they first apply to become a
lottery retailer. In the past, such credit checks were also performed on an annual basis
during the license renewal process. However, the Lottery has not renewed retailer licenses
since 1991. Therefore, only first-time retailers have had credit checks performed in the past
six years. The Lottery should consider reinstituting routine credit checks which could be
19
performed annually, as was done in the past, or every 3 years, as the Lottery Director is
currently proposing. The Lottery should develop guidelines to assist in determining the
creditworthiness of applying retailers. Such guidelines could require that retailers deemed
a high credit risk provide surety bonds or other guarantees of payment.
Lottery Has Failed to Ensure That
Retailer Distribution System
Is Cost-Effective
In addition to not making sure that retailers pay their bills, the Lottery has also not en-sured
that its retailers are profitable to the Lottery. Even though Lottery rules set sales
minimums that retailers must meet, the Lottery has done nothing to enforce those rules.
The Lottery needs to enforce minimum sales requirements to ensure that the cost of serv-icing
a retailer does not exceed the revenue generated from that retailer. By eliminating
unprofitable retailers, the Lottery also could add new, potentially lucrative retailers to its
distribution network.
Sales minimums not met—The Lottery does little to ensure that lottery retailers meet its
minimum on-line ticket sales requirement. As of February 28, 1997, 27 percent of the re-tailers
did not meet Lottery administrative rules that require sales of at least 400 on-line
tickets per week during the preceding 10-week period. Some retailers= sales fell far below
the minimum. For example, a market in Chandler sells an average of only $33 in on-line
tickets per week, and a check-cashing store in Phoenix sells an average of only $15 in on-line
tickets per week.
Many retailers also perform very poorly in instant ticket sales. Twenty-six percent of re-tailers
who sell instant tickets failed to sell more than an average of $250 worth of tickets
per week during the same 10-week period for all instant games they offered, which is far
below the Lottery’s minimum for instant ticket sales. The Lottery’s rule requires retailers
to sell $250 worth of tickets on average per week during the same 10-week period for every
instant ticket game offered.
Other states, such as Florida, Missouri, New Jersey, and Ohio, not only set but enforce
sales minimums for lottery retailers. Ohio sends poorly performing retailers a notice that
they must meet sales minimums within six weeks or lose their selling privileges. Florida
revokes on-line machines from retailers who fail to meet minimums except for retailers in
rural areas of the state, where customer accessibility may be an issue. Missouri and New
Jersey are more reluctant to revoke the licenses of retailers who do not meet sales mini-mums.
Instead, lottery sales representatives in these states work with poorly performing
retailers to increase their sales to meet established minimums.
20
Lottery incurs costs for unproductive retailers—The Lottery needs to ensure that its retail
outlets generate a minimum level of sales since it incurs several types of costs by allowing
a retailer to operate. For example, it costs the Lottery $58 per month in phone charges, on
average, to let a retailer operate an on-line ticket machine (actual costs vary according to
location). Nonetheless, during the 10-week period prior to February 28, 1997, the average
ticket sales of 35 on-line retailers did not even cover these phone costs.
The Lottery assumes additional costs from installing and operating on-line machines.
However, the Lottery has not determined what these costs are and, therefore, does not
know what the break-even amount is for operating an on-line retailer. Finally, the Lottery
incurs additional costs associated with the delivery of instant tickets and promotional
materials to lottery retailers. Almost all such deliveries are made in person by sales staff,
thus costing the Lottery travel expenses and staff time.
In addition to direct costs, the Lottery may incur an opportunity cost in the future by al-lowing
unproductive retailers to operate. The Lottery’s current contract with its on-line
machine supplier limits the number of on-line ticket machines available to 2,560, thus lim-iting
the number of potential retail outlets. As a result, the Lottery will not be able to issue
new licenses once the maximum number of outlets is reached. Thus, applicants with high
sales potential or large chains with new locations could be denied licenses in the future
unless unprofitable retailers’ licenses are canceled.
Some other states charge their retailers fees to cover costs associated with allowing retail-ers
to operate. For example, the Maryland Lottery requires retailers to pay for the on-line
installation fee and a monthly administration fee of $90. The Idaho Lottery requires retail-ers
to pay $50 monthly to cover on-line charges. Additionally, Florida and Ohio charge
retailers weekly administration fees of $10 and $12, respectively. The Arizona Lottery
could impose such fees if it determines what its break-even costs are for operating on-line
retailers.
Unproductive retailers’ licenses should be revoked—To ensure that resources are used ef-ficiently,
the Lottery should cancel licenses of retailers who fail to meet minimum sales re-quirements.
However, when this audit ended, the Lottery had failed to take any such ac-tion.
21
Recommendations
1. The Lottery should better enforce its rule for revoking the licenses of retailers who
continually have insufficient monies to pay for Lottery tickets they have sold.
2. The Lottery should attempt to collect the money retailers owe for tickets they have
sold. The Lottery should do this by:
n Sending out notices to retailers informing them that their licenses will be canceled if
they fail to pay the amount owed;
n Requesting the Department of Revenue to intercept tax refunds for individuals
who own sole proprietorships or partnerships that owe money for tickets sold; and
n Referring retailers who fail to pay their bills to collection agencies.
3. The Lottery should routinely conduct credit checks of retailers as part of its licensing
process and develop guidelines to assist in determining the creditworthiness of ap-plying
retailers. Such guidelines could require that retailers deemed a high credit risk
provide surety bonds or other guarantees of payment.
4. The Lottery should revoke the licenses of retailers who fail to meet minimum sales lev-els
for on-line and instant ticket sales as required by its administrative rules.
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23
FINDING III
LOTTERY DOES NOT ADEQUATELY
PROTECT CASH ON HAND AND OTHER
STATE ASSETS
The Lottery can help prevent loss and theft of cash and assets by instituting and enforcing
an adequate system of internal controls. Currently, the Lottery lacks a good system of in-ternal
controls, which increases the risk of fraud, waste, and abuse of state assets. Further,
poor management practices contribute to a waste of state assets. The Lottery should cor-rect
several factors that contribute to poor internal controls.
Lottery Fails to Sufficiently
Protect State Assets
The Lottery does not have adequate managerial and procedural controls to protect state
revenues and assets against potential fraud, waste, or abuse. Specifically, the Lottery fails
to protect cash, prizes, and inventory, which could result in loss or theft. Further, the Lot-tery
uses poor management practices, including inadequate oversight of its advertising
contract, which decreases its ability to operate efficiently.
Due to the high volume of Lottery activities involving cash and inventory, it is important
that the Lottery maintain adequate internal controls. Internal controls are measures
adopted within an organization to safeguard its assets, check the accuracy and reliability
of its accounting data, promote operational efficiency, and encourage adherence to pre-scribed
managerial policies. Without adequate internal controls, the likelihood of the Lot-tery
losing cash, inventory, or other assets to fraud, waste, or abuse greatly increases.
Lottery fails to protect cash, prizes, and other inventory—The Lottery’s current internal
controls do not sufficiently protect cash, prizes, and promotional inventory. The lack of
adequate internal controls could result in loss, theft, or inefficient use of these resources. A
review of the Lottery’s internal controls revealed the following weaknesses:
n Cash on hand not protected—The Lottery fails to adequately protect cash in its retail
stores and vaults. The Lottery operates retail stores in both Phoenix and Tucson, which
sell Lottery tickets and merchandise, validate winning tickets, and pay cash prizes over
$600 by check. These retail stores’ cash vaults contain excessive amounts of cash. For
example, the retail stores only need a daily cash balance of approximately $10,000 to
24
operate. However, the Phoenix vault had an average balance of $30,000 and Auditor
General staff counted as much as $58,000 in the vault. Further, in the Tucson store, em-ployees
have unlimited access to cash drawers and the vaults during the day. The Tuc-son
store does not maintain a log identifying which employees accessed the vault or
the amount of each withdrawal or deposit. Although the Lottery has not discovered
any loss or theft of cash, the Lottery could not readily determine if it did occur due to
the lack of internal controls.
n Lack of control over revolving fund—The Lottery does not maintain adequate con-trol
over its revolving fund bank account. The Lottery maintains the revolving fund to
make payments for postage, shipping, subscriptions, and miscellaneous expenses, and
to replenish its petty cash fund. Although the revolving fund is maintained with an
average balance of $30,000, a fund balance of $5,000 would be sufficient for Lottery
needs. When Auditor General staff examined revolving fund expenditures for their
appropriateness, supporting documents for 12 of 30 expenditures could not be located.
In addition, the revolving fund has a balance discrepancy of approximately $4,600,
which cannot be explained since supporting documentation has not been maintained.
n Prizes and promotional items mismanaged—The Lottery does not properly control
and distribute its prizes and promotional items. As of December 1996, the Lottery had
more than $200,000 in promotional items (shirts and hats) and approximately $150,000
in prizes in its warehouse. Prizes include $100 baseball bats and $200 autographed
sports jerseys, which were part of a sports-themed Lottery game. Auditor General staff
inventoried 10 types of promotional merchandise, such as shirts and hats, and found
that none of the inventory counts agreed with the Lottery’s records. Lottery inventory
records either over- or under-counted seven of the ten types of promotional items,
while three of the types of items inventoried were not even listed on the Lottery’s rec-ords.
Without accurate inventory control, the Lottery cannot plan for the effective use
of its promotional items or detect any loss or theft problems. In addition, Lottery staff
have inappropriately distributed game prizes to retailers and others as incentives or
promotional items. For example, Lottery employees gave away more than $6,000 in
prizes, such as autographed bats and baseballs, to individuals and companies who are
unaffiliated with the Lottery or its retailers. These gifts violated A.R.S. §5-523 because
they were purchased with monies designated for prizes. However, the Lottery is al-lowed
to give promotional items, if it uses appropriate monies designated specifically
for that purpose. When auditors informed Lottery officials of the specific provisions
governing promotional items, the Lottery transferred monies from the promotions ac-count
to correct the problem.
n No segregation of duties—The Lottery does not properly segregate its employees’
duties. Lottery employees who sell and redeem tickets are also responsible for recon-ciling
monies contained in the cash vaults. These employees use the same cash drawer
for all transactions and have unlimited access to both cash drawers and vaults during
the day. In addition to physical security problems, one employee has inappropriate
25
electronic security access on the Arizona Financial Information System (AFIS) to enter
new vendor information and release payments for processing, which could lead to
fraudulent activity. Further, the duties of receiving, issuing, accounting, and storing
inventories are not segregated, which could lead to undetected loss.
n Payroll not checked—The Lottery does not have written internal policies and proce-dures
to address the preparation and processing of payroll, journal entries, and trans-fers
of cash between accounts. Calculations of employee wages and associated deduc-tions
are not periodically checked by either the payroll or internal audit departments.
Although Auditor General staff discovered only a few minor problems with the Lot-tery’s
payroll, employee turnover and a lack of sufficient training may contribute to
future payroll problems.
Lottery does not ensure its advertising money is effectively spent—The Lottery does not
provide sufficient oversight of its advertising contract, even though it pays $8 million an-nually
to a firm that acts as the principal advertising and marketing planner for all Lottery
games. The Lottery does not have written policies and procedures for administering the
contract and has never performed compliance reviews. By using written policies and pro-cedures
and compliance reviews, the Lottery can ensure that advertising charges are ap-propriately
authorized and that contract obligations are consistently met.
Further, during August 1995, the contract was modified to allow the Lottery to pay for
actual services provided plus a 10 percent markup instead of paying a flat 10 percent of its
budget for contracted advertising. Although this amendment would have decreased the
amount of compensation paid to the firm for the same services, the Lottery never enforced
the amended terms. Additionally, the Lottery sometimes bases its payments on estimated
charges instead of actual billing invoices. However, the Lottery has no authority to pay in
advance or prior to receiving an invoice. Without actual invoices, the Lottery cannot de-termine
if advertising spots it paid for were ever broadcast by media companies.
Finally, the Lottery’s advertising contract language does not establish limits on the types
or amounts of the advertising agency’s travel costs that will be reimbursed. The contract
also allows the firm to mark up administrative costs to which the agency has added no
value, such as postage, telephone calls, and deliveries.
A 1995 special audit conducted by the Auditor General identified most of the problems
with the Lottery’s advertising contract discussed above. However, as of the end of this
audit, the Lottery had still not resolved many of the outstanding issues identified with its
advertising contract.
26
Lottery Should Correct Several
Factors That Contribute to a Poor
Internal Control Environment
To ensure state cash and assets are adequately safeguarded, the Lottery needs to improve
its internal controls. First, the Lottery needs to ensure that effective internal control poli-cies
and procedures are developed for all functions and are distributed to all employees.
Second, the Lottery needs to provide training so that employees can effectively perform
their duties. Third, high turnover and job vacancies, which can adversely affect internal
controls, should be addressed by the Lottery. In addition, the Lottery can use its internal
audit staff to ensure compliance with policies and procedures and provide management
with important decision-making information. Finally, the Lottery needs to better monitor
its advertising contract. Although the Lottery has begun to improve its internal controls
and business practices, more can be done.
Lottery needs written policies and procedures—The Lottery needs written policies and
procedures to guide its employees in the performance of their duties. Policies and proce-dures
should clearly outline individual employees’ specific authority and responsibility,
thus establishing employee accountability. Policies and procedures also guide employees
on the proper handling of less-frequently encountered transactions and situations. Fur-ther,
a policies and procedures manual lessens the threat to continuity posed by employee
turnover. Currently, the Lottery lacks written policies and procedures in several areas. In
order to strengthen the internal control environment, the Lottery needs to ensure the fol-lowing
areas are addressed:
n Cash-handling procedures limiting access to cash drawers and vaults, as well as re-cording
information related to the movement of cash within Lottery retail stores. Du-ties
involving cash should be segregated, so that employees responsible for ticket sales
and redemptions do not also reconcile cash accounts.
n Inventory procedures ensuring employees know how to record and process various
items including tickets, prizes, and promotional items. Further, employees should rec-ognize
limitations placed on prize and promotional item giveaways. Planning and
written policies and procedures could help the Lottery properly and effectively use
promotional items and instant tickets so that resources are not wasted.
Employee training needs to be increased—The Lottery needs to ensure that its employees
are properly trained. Training, both formal and on-the-job, is essential to ensure employ-ees
are properly prepared to perform all aspects of their jobs. During the audit, several
employees stated that they have received little or no training directly relating to the duties
they are currently performing. Although the Lottery may hire individuals with the appro-priate
skills, employees’ responsibilities have expanded beyond their areas of expertise.
27
Turnover needs to be addressed—Several lower- and mid-level vacant positions have not
been filled by the Lottery. Specifically, the Lottery has vacancies in several positions in-cluding
computer programming manager, accounting supervisor, retailer promotions,
warehouse operations, and retailer licensing investigators. Job vacancies such as these can
increase the responsibilities of other employees, who may not have been adequately
trained for them. Some Lottery managers stated that several job vacancies have limited the
Lottery’s ability to appropriately segregate its employees’ duties. This situation decreases
oversight of employees and increases the risk of loss or theft.
Internal audits important—Lottery internal audits are inadequate due to their limited use.
Internal audits help ensure that an agency is operating properly, and detect and reduce
the risk of loss or theft. Further, internal audits could address the Lottery’s internal control
problems and provide management with more information for effective decision-making.
Although the Lottery has an internal audit staff, internal auditors rarely review Lottery
activities. Currently, internal auditors inventory instant tickets after the end of each Lot-tery
game and perform limited reviews of contractor billings. However, internal auditors
have never reviewed the Lottery’s advertising contract, for example, to determine if the
advertiser is following proper procurement practices. Finally, internal auditors should
conduct follow-up reviews to ensure that problems identified are subsequently corrected.
Lottery has begun implementing changes—In response to discussions with Auditor Gen-eral
staff, the Lottery has begun efforts to improve its internal control environment. For
example, Lottery staff recently organized the warehouse, separating instant tickets from
prizes and promotional items. One Lottery manager has been assigned direct responsibil-ity
for promotional items, which can be used as incentives for retailers. Although such a
change is a step in the right direction, the Lottery should review all aspects of its internal
control environment and continue implementing changes as needed.
28
Recommendations
1. The Lottery should improve internal controls to safeguard cash and inventories, and
access to vaults should be limited. The Lottery should also ensure that fund and vault
balances are not excessive.
2. The Lottery should review its management of the revolving fund, including more fre-quent
reconciliations. Further, the revolving fund’s balance should be consistent with
the Lottery’s actual needs.
3. The Lottery should emphasize job-specific and internal control training for all employ-ees.
Adequate oversight should be provided to ensure procedures are consistently fol-lowed.
4. The Lottery should ensure that adequate policies and procedures are developed re-garding
all aspects of internal controls, particularly those relating to cash-handling, in-ventory,
and segregation of duties.
5. The Lottery’s internal audit unit should conduct more audits, including adherence to
policies and procedures, internal control compliance, and review of Lottery contracts
and payments to vendors. The unit should give special attention to the Lottery’s ad-vertising
contract, which involves millions of dollars each year and which has a history
of problems and poor oversight.
29
FINDING IV
SIGNIFICANT WEAKNESSES EXIST IN
LOTTERY COMPUTER SYSTEM
Significant weaknesses exist in the Lottery’s computer system, which may compromise the
system and adversely affect the Lottery’s ability to operate. Weak computer access con-trols
expose the Lottery to potential fraud. Further, the Lottery’s computer system lacks
critical elements that would ensure operations continue in the event of a disruption.
Background
The Lottery relies on electronic data processing for many operations. For example, retail-ers
selling tickets for on-line games, such as Lotto and Powerball, scan players’ number
selections into a computer that transmits them by phone line to the Lottery’s contractor
and ultimately the Lottery’s own computer. Information about player picks, as well as the
total value of tickets sold, is used after the official drawing to determine the prize amount
paid to each player who holds a ticket containing numbers matching the number drawn.
The Lottery also uses computers for several other functions, including verifying winning
tickets, calculating and collecting sales revenue from retailers, telemarketing, and ac-counting.
Lottery Computer System
Lacks Adequate Security
Despite the importance of its computer system, the Lottery does not adequately protect
the system from unauthorized access. Lack of adequate control over the computer system
creates a high exposure to potential fraud and abuse by employees and outside parties.
Several aspects of the Lottery’s computer system contribute to the lack of adequate secu-rity,
including:
n Staff have inappropriate access—Some computer operators have inappropriate ac-cess
to the Lottery’s computer system. These employees have the security administra-tor
level of authority, which allows them to manipulate data and add or delete other
computer users. Further, software connecting employees’ computers to the Lottery’s
AS400 computer system contains a file transfer program, which allows employees to
upload and download files regardless of access rights. Thus, employees with access to
30
the AS400 computer system have the ability to make major alterations to Lottery data.
Although a planned computer system upgrade will not include this program, the pres-ent
system does not adequately protect some important data. Further, until recently,
employees who were transferred or resigned could still access the computer system
and alter or delete computer data and files. Computer users should have more limited
access to the Lottery system, restricting them to data and information that is required
for their duties. Only computer system management and administrators should have
unlimited security administrator authority.
n Access information is not documented—The Lottery does not record employee ac-cess
to its computer system. Although the Lottery has forms for recording computer
access, as well as forms that employees sign indicating they will not divulge confiden-tial
information, neither form is currently used. Because these forms are not used, Lot-tery
staff may not be aware that the information they are accessing is confidential.
n Policies and procedures are inadequate—The Lottery lacks written policies and
procedures regarding its computer system. For example, software program instruction
and problem-solving manuals have not been maintained since a new contractor took
over in 1996. Further, Auditor General staff noted a general lack of policies and proce-dures
regarding computer system basics, such as security, operations, and system fail-ures.
Due to this lack of documentation, Auditor General staff were unable to deter-mine
if losses have occurred as a result of inappropriate security on the Lottery’s com-puter
system.
n No security administrator for computer system—The Lottery’s computer system,
local area network, and financial management system security is not centralized into
one security administrator position. This lack of centralized security can lead to secu-rity
gaps that could allow unauthorized access to the computer systems.
Moreover, turnover in a key Lottery management position has contributed to inadequate
Lottery computer security and has adversely affected long-term planning. Since 1982, the
Lottery has had nine different Management Information Systems Directors, who have re-sponsibility
for computer system security, operations, coordination of resources among
departments, and strategic planning. This lack of continuity prevents the Lottery from de-veloping
and implementing comprehensive strategic plans for the Lottery’s computer
systems and personnel. Lottery employees indicated that high management turnover has
adversely affected long-term planning and has contributed to inadequate Lottery com-puter
security.
31
Computer System Lacks Adequate
Backup Capabilities and
Disaster Recovery Planning
Although the Lottery relies heavily on electronic information, its computer system lacks
adequate contingency elements, such as backup capabilities and disaster recovery plan-ning,
that would help it continue operations in the event of a system failure. First, the
Lottery’s computer system lacks capabilities for backing up critical electronic data. Sec-ond,
although the Lottery has a disaster recovery plan, the plan has never been tested. Fi-nally,
the Lottery relies on a single data line, instead of obtaining a second line that would
allow the Lottery to continue operations should the primary data line fail.
n No backup processor—Although a backup processor is required for participation in
the multi-state Powerball game, the Lottery currently has only a single processor on its
computer system. Should a disruption occur, the Lottery would be unable to continue
operations, such as instant ticket validations and on-line game sales, for possibly days
or even weeks, until the processor is repaired. Further, a disruption to the Arizona
Lottery computer system would disable the entire Powerball game, adversely impact-ing
20 participating states and thousands of players. Should the computer system fail,
Arizona could be subject to lawsuits from the multi-state association that oversees
Powerball, other states, retailers, and individual players. Despite the importance of a
backup processor, funding was not provided for one when the Lottery purchased and
installed its computer system. To help address this problem, the fiscal year 1998-99 ex-ecutive
budget recommends $607,000 for a backup processor and improvements to
protect ticket validations and the Lottery’s business operations.
n Disaster recovery plan untested—Currently, the Lottery relies on an untested plan
written by its contractor, which has never been updated by Lottery staff. Disaster re-covery
plans help ensure that business can continue in the event of a disastrous event
such as a fire, a natural catastrophe like a flood, or acts of negligence, such as dropping
a disk pack. Planning is necessary to ensure that adequate security measures and con-trols
are maintained both during and following a computer disruption. However, the
Lottery has never tested its plan or simulated a catastrophe that would disrupt Lottery
operations. Further, there is no copy of the plan stored off-site, and several critical em-ployees
do not know the disaster recovery plan exists.
n Data line lacks backup—The Lottery uses a high-speed computer data line between
its office and its contractor to transfer data and to validate instant tickets. Currently,
the Lottery has only one-high speed data line to its contractor and if it fails, instant
tickets could not be validated. A second high-speed data line would allow the Lottery
to shut off the primary data line and easily continue operations. Lottery officials plan
to add a second data line, which would cost approximately $450 to install and $400 per
month to operate.
32
Recommendations
1. The Lottery should develop and distribute written policies and procedures regarding
its computer system.
2. The Lottery should improve security on its computer system by:
a. Reviewing access to the system to ensure employees’ access rights are appropriate
to the duties they perform;
b. Ensuring that when upgraded, the AS400 computer system does not include soft-ware
that gives all employees the ability to download, alter, and upload data re-gardless
of user access rights; and
c. Consolidating its computer system’s security and administration into a single staff
position.
3. The Lottery should enhance its computer system to address problems associated with
disruptions by:
a. Installing a backup, or redundant, processor on its computer system;
b. Testing and revising the disaster recovery plan; and
c. Installing a second high-speed data line between the Lottery and its contractor.
33
SUNSET FACTORS
In accordance with Arizona Revised Statutes (A.R.S.) §41-2354, the Legislature should
consider the following 12 factors in determining whether the Arizona Lottery Commission
should be continued or terminated.
1. The objective and purpose in establishing the Lottery.
The Arizona Lottery Commission was proposed by initiative petition and ap-proved
by voters in the November 1980 general election. The Lottery Commission’s
purpose is “to produce the maximum amount of net revenue consonant with the
dignity of the state.” The Lottery attempts to meet its mission by offering the public
instant ticket games and on-line games.
2. The effectiveness with which the Lottery has met its objective and purpose
and the efficiency with which it has operated.
Though it has not produced “the maximum amount of revenue” possible, the Lot-tery
has generated almost $3 billion in revenue since it began operations in 1981,
and contributed over $1 billion in net revenue to the State. Nonetheless, Lottery
revenues fare poorly when compared to other states. In fiscal year 1996, the Lottery
ranked 35th out of 38 state lotteries in per capita sales. While some factors affecting
sales have been outside of the Lottery=s control, reduced management turnover,
better planning and promoting of games, more productive use of staff time, and a
variety of innovative sales techniques could lead to higher sales (see Finding I,
pages 7 through 16).
While the Lottery could improve its sales revenue, it has made strides in reducing
its administrative costs over the years. As a result of an Auditor General recom-mendation
from a 1987 performance audit (Auditor General Report 87-3), statute
was changed, requiring the Lottery to spend no more than 18.5 percent of total
revenues on administration, as opposed to the 25 percent limit that was previously
allowed. The Lottery complied with the statutory change, and has maintained ad-ministrative
expenses within the allowable limit.
3. The extent to which the Lottery has operated within the public interest.
Determining the extent to which the Lottery operates within the public interest de-pends
on individual beliefs regarding public-sponsored gambling. Proponents ar-
34
gue that the Lottery has operated within the public interest by generating substan-tial
net revenues that are apportioned to a variety of designated funds used for
public services. However, critics maintain that the Lottery is a form of state-sponsored
and state-advertised gambling. Such critics maintain that social costs as-sociated
with raising such revenue are unknown, and may in fact exceed the public
benefit gained from lottery sales.
4. The extent to which rules and regulation promulgated by the Lottery are con-sistent
with the legislative mandate.
According to the Governor=s Regulatory Review Council, the Lottery=s current rules
are within the Lottery’s broad statutory parameters. However, the Executive Di-rector
has not adopted one rule required by statute. No rule exists regarding the
manner in which a licensed retailer displays a license, even though A.R.S. §5-512(G)
requires such a rule.
In addition to this rule deficiency, two Lottery rules contain flaws regarding the
number of days given for requesting review or rehearing. Currently, Lottery rules
only give a person 10 days to file a written request of a Commission decision to re-voke,
suspend, or deny a retailer license. Similarly, Lottery rules only give “any
party who is aggrieved by a decision of the Director concerning a contract claim or
controversy” 10 days to file a written request for rehearing. In both cases, these
rules are inconsistent with Dioguardi v. Superior Court of Arizona. The Court held
that 15 days be provided for requesting a review or rehearing.
5. The extent to which the Lottery has encouraged input from the public before
promulgating its rules and regulations and the extent to which it has in-formed
the public as to its actions and their expected impact on the public.
The Commission has adequately encouraged input from the public before promul-gating
its rules and regulations. Proposed rules are summarized in the Administra-tive
Register. Any proposed rule is placed on a regular Commission meeting
agenda for consideration. Meeting notices are posted at the Lottery’s offices in
Phoenix and Tucson.
35
6. The extent to which the agency has been able to investigate and resolve
complaints that are within its jurisdiction.
The Lottery is not a regulatory agency. Therefore, it does not receive formal com-plaints.
However, the Lottery does receive and respond to a variety of informal
complaints, such as complaints about lottery terminals from retailers.
7. The extent to which the Attorney General or any other applicable agency of
state government has the authority to prosecute actions under enabling leg-islation.
A.R.S. §5-512.01 provides both the Attorney General and county attorneys concur-rent
prosecution authority for an offense arising out of or in connection with the
formation, management, operation, or conduct of the State Lottery.
8. The extent to which the agency has addressed deficiencies in the enabling
statutes which prevent it from fulfilling its statutory mandate.
In 1997, Lottery officials requested the introduction of legislation that they believed
would allow the Lottery to operate more like a “business” and generate higher
sales. The proposed legislation sought broad exemptions from state budgetary,
rule-making, and personnel restrictions. Since only limited changes were enacted
during the 1997 session, the Lottery Director plans to seek similarly broad legisla-tive
changes in the future. While some proposed statutory changes may be benefi-cial
because they increase flexibility in Lottery operations, the Legislature should
consider how such changes could benefit Lottery operations in light of this report
and the possibility of abuse of public trust (see Sunset Factor 12, page 37, for further
information).
Other statutory changes did occur during the 1997 legislative session. Among other
provisions, Laws 1997, Chapter 1 increased the prize percentage amount that the
Lottery can return to players, eliminated certain rule-making requirements, in-creased
the commission rate paid to retailers, and exempted Lottery sales staff from
state personnel rules.
One provision of Laws 1997, Chapter 1 increased the prize payout percentage of
total revenues that the Lottery can return to players. Lottery officials believe that
increasing this percentage will generate higher sales. However, the correlation be-tween
increased prize payout percentage and higher sales is unknown. In fact,
seven of the Lottery’s top ten performing instant ticket games over the past two
years had lower percentages devoted to payout than the percentage requested by
the Lottery. Additionally, one-third of states with higher per capita sales than Ari-zona
have lower prize payout percentages than Arizona. If sales do not increase as
36
a result of a higher prize payout, less monies will be generated for state programs
since a higher percentage of sales will be distributed to players.
9. The extent to which changes are necessary in the laws of the agency to ade-quately
comply with the factors listed in the sunset law.
Statutes outlining the distribution of Lottery fund proceeds need to be clarified.
Current statutes are ambiguous as to whether net revenue from the Powerball
game should be distributed to the General Fund only or should be lumped with
other Lottery game revenues and distributed to different fund recipients.
The confusion exists due to two ambiguous statutory provisions. The first, A.R.S.
§5-504(D), states that multi-state Lottery game monies (such as Powerball) “shall be
accounted for separately as nearly as practicable in the lottery commission’s general
accounting system.” The language “shall be accounted for separately” could be in-terpreted
as a mere bookkeeping requirement. However, the Joint Legislative
Budget Committee staff have interpreted it to mean that Powerball net revenue
should go directly to the General Fund, while other Lottery revenue should be de-posited
to the State Lottery Fund, where it can subsequently be distributed to other
state and local funds. Adding to the confusion, statute states that Lottery proceeds
shall be deposited in the State Lottery Fund, yet the statute is silent regarding
which fund should receive multi-state lottery game monies.
The Legislature should clarify language concerning the distribution of the Lottery’s
net revenues to ensure that distribution reflects legislative intent.
10. The extent to which the termination would significantly harm the public
health, safety, or welfare.
Terminating the Lottery would not have a detrimental effect on the public health,
safety, or welfare. However, terminating the Lottery would eliminate a significant
amount of revenue made available to the State. The Arizona Lottery has generated
an average of approximately $72 million annually for state programs since its in-ception.
11. The extent to which the level of regulation exercised by the agency is appro-priate
and whether less of more stringent levels of regulation would be ap-propriate.
The Lottery is not a regulatory agency. However, statute requires the Lottery to li-cense
lottery retailers, giving retailers the right to sell on-line and instant lottery
tickets. Lottery licenses currently expire at the end of one year. Since 1991, the Lot-
37
tery has issued licenses only to new retailers, and has not issued any renewal li-censes
to existing retailers. As a result, the vast majority of lottery retailer licenses
are currently expired.
The Lottery is proposing changing its rules so that the retailer licenses are valid for
two years. If implemented, two-year licenses would enable the Lottery to catch up
and keep current with license renewals. Retailer licenses such as those granted by
Wisconsin (three years) and Florida (four years) last for longer periods of time than
proposed for Arizona. It is important to note that such license duration should not
be indefinite, since functions tied to license renewal, such as criminal background
and credit checks, are performed at the time a license is issued or reissued.
12. The extent to which the agency has used private contractors in their per-formance
of its duties and how effective use of private contractors could be
accomplished.
Current Contracts
The Arizona Lottery makes extensive use of private contractors in the performance
of its duties. Private contractors provide instant game tickets; on-line game systems,
services, and tickets; annuities to fund grand prizes; advertising; sponsorships; and
promotional materials. Additionally, the Arizona Lottery is using a private con-tractor
to develop its most recent request-for-proposal for an on-line game system.
Private contractors also perform auditing and lobbying functions for the Lottery.
Considerations on Regarding
Efforts to Privatize the Lottery
Some states have privatized their entire lotteries. States such as Connecticut, Geor-gia,
Kentucky, Louisiana, and New Mexico have created “quasi-governmental”
agencies, allowing these state lotteries to operate with no or limited budgetary
oversight by the legislature. In many of these states, the lotteries are also exempt
from state rule-making, personnel, and procurement restrictions. Lottery directors
in these states report that such exemptions allow them to respond more quickly to
changing market conditions, and operate more like revenue-generating businesses.
Though Arizona is prohibited by the Arizona Constitution from creating a “quasi-governmental”
corporation, some of the alleged restrictions on operations could be
modified through statutory change. The Lottery could become more like these
38
quasi-governmental entities if statute freed the Lottery from budgetary, rule mak-ing,
and personnel restrictions. If enacted, these statutory changes could allow the
Lottery to respond more quickly to changing market conditions. For example, it
could allow the Lottery to enact new on-line games more quickly, and to purchase
new equipment, such as scanners for validating instant tickets.
While statutory changes may make it easier for the Lottery to operate more like a
“business,” it is also important for the State to maintain control and oversight
mechanisms. Abuse of the public trust is possible. In both private and public state
lotteries, scandals have occurred in recent years involving kickback schemes by
contractors and nepotism. Scandal has also been associated with the Lottery’s cur-rent
on-line contractor, which provides 70 percent of the on-line services to lotteries
worldwide. In October of 1996, the company’s former national sales manager was
convicted of orchestrating a kickback scheme using inflated payments to state-level
political consultants. According to a November 11, 1996, Fortune Magazine article,
this contractor is also under investigation by the Securities and Exchange Commis-sion
and federal prosecutors in Texas.
Agency Response
(This Page Intentionally Left Blank)
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 1
Finding I Recommendations:
Audit Statement: The Lottery should update current on-line games like Lotto and Fantasy
5, instead of solely relying on new on-line games, in order to boost sales.
Response: The finding of the Auditor General is agreed to and a different method of
dealing with the finding will be implemented.
$ It has been public policy in recent years that the Lottery implement or change new
and existing games very slowly. Recently the Lottery has been given the authority
to make changes in the current games, i.e. Lotto, Fantasy 5.
$ The Lottery will be making changes to Fantasy 5 this year and MUSL-mandated
changes to Powerball take effect November 2, 1997. These changes are designed
to create higher jackpots, attract additional players and increase play from current
players. Research demonstrates players are resistant to major changes in Lotto;
minimal modifications may be made later this year.
Audit Statement: The Arizona Lottery should implement long-term planning to increase
sales and evaluate actual Lottery performance.
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ In an effort to increase long range planning, the Marketing Department completed
and distributed to all departments the 1998 Fiscal Year marketing plan in April. In
addition, the new on-line contract will require the selected vendor to compile a five
year long range plan that will set forth goals to increase sales and measure
effectiveness. A rough draft of this plan should be completed by February 1, 1998.
Audit Statement: The Lottery should consider better utilizing sales staff, including finding
ways to better handle ticket delivery and the Americans with Disabilities Act compliance
issues, which would allow sales staff more time to increase sales.
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ Past Lottery Directors have been reluctant to staff sales representative positions at
a level that would better support an increasing retailer base and an ever-growing
complement of game products. The responsibility of implementing and monitoring
retailer compliance with the American with Disabilities Act (ADA) has limited the
sales staff effectiveness. Most lotteries assign each rep 50 to 60 retailers; our staff
must serve 90 to 160 retailer locations.
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 2
Finding I Recommendations (continued):
$ Current management has committed to implementing courier delivery service for
retailer distribution of Instant game tickets in the near future. This will enable the
sales representatives to use their time on other activities that will promote additional
product sales in their assigned retailers.
Audit Statement: The Lottery should consider utilizing innovative practices proven to
increase sales, such as adding games to its current game mix; shortening the time specific
games are offered; using direct mail, co-promotions, and in-store advertising materials;
introducing multiple priced games; and redesigning prize payout structures so that there
are more lower-tier winners and repeat players.
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ Many of the suggestions detailed in the Auditor General=s findings have already
been recognized by Lottery staff:
$ The Lottery has introduced Arizona Bingo, a new on-line game. An additional
on-line game and pull-tabs may be added to refresh the current game mix. In the
private sector, new ideas can be implemented on an aggressive schedule.
Because each Arizona citizen is a stakeholder in our >business= we must address
a wide variance of supporters and detractors with every attempt to broaden our
market. This lengthens the process, and our ability to respond quickly.
$ Scratcher tickets are now being marketed with a strategy that offers more games
(with wider appeal) to our customers for a shorter play time. Keeping the product
mix entertaining is a key element for increased Scratcher sales.
$ Scratcher and on-line games will benefit from multiple-pricing levels, with $2 and
$3 tickets added as alternatives to $1 games. The Scratcher prize payout
percentage has gone from 50% to an average of 60%, and increased the number
of low-tier winners.
$ Direct marketing to players is an option many lotteries employ. Marketing staff are
researching the effectiveness of this in other states. A program tailored to Arizona
players may be introduced if the effectiveness can be proven.
$ Co-promotions with retailers were tested in March 1997. The success of these
programs, with the resulting increased awareness, ensures that similar programs
will be implemented in the future. Promotion samples are available upon request.
$ The retailer incentive program now being developed includes an aggressive in-store advertising
plan. Participating retailers will be required to post additional point-of-sale (POS) advertising
materials as part of the program.
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 3
Finding I Recommendations (continued):
Audit Statement: The Lottery should consider obtaining additional ITVMs through lease
or purchase, and acquire other technologically advanced equipment.
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ Self-service vending machines (ITVM) were budgeted and installed in December,
1993. In the first year, additional units brought the total to 221 installed in high
volume customer locations. These units are designed for supplemental sales,
especially in supermarket locations that have high on-line, but much lower instant
ticket sales. In locations with more than one entrance and multiple checkout areas,
the units provide a way for the player to purchase a wider variety of instant tickets
without a lengthy wait in line. Winning tickets must be redeemed at customer
service counters where additional ticket dispensers are located; customers can
purchase more tickets with their winnings without returning to the ITVM.
The Marketing division has requested additional ITVMs as part of the annual
legislative budget process for the past three years without success.
The new on-line contract calls for a total of 600 new 12-bin ITVMs starting January
1, 1998.
The Lottery is now implementing in-counter ticket dispensers at selected locations.
Retailers with sufficient counter space may request the dispensers, which offer a
way to effectively display more instant games.
Audit Statement: The Lottery should monitor the effect of a recent change in its retailer
incentive program and be prepared to propose a restructured incentive program to the
Legislature if the current plan does not help to increase sales within two years.
Response: The finding of the Auditor General is agreed to and the audit
recommendation will be implemented.
$ The planned incentive program will be monitored on a regular basis to ensure
retailer compliance. Quarterly reviews will be used as a tool to help the retailer meet
or exceed sales quotas. During the first year, adjustments may be made to the
program to better meet the needs of the retailers.
Audit Statement: The Lottery should better enforce its rule for revoking the license of
retailers who continually have insufficient monies to pay for Lottery tickets they have sold.
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 4
Finding II Recommendations:
Audit Statement: The Lottery should attempt to collect the money retailers owe for tickets
they have sold. The Lottery should do this by:
a. Sending out notices to retailers informing them that their licenses will be canceled
if they fail to pay the amount owed;
b. Requesting the Department of Revenue to intercept tax refunds for individuals who
own sole proprietorships that owe money for tickets sold; and
c. Referring retailer who fail to pay their bills to collection agencies.
Audit Statement: The Lottery should routinely conduct credit checks of retailers as part
of its licensing process and develop guidelines to assist in determining the creditworthiness
of applying retailers. Such guidelines could require that retailers deemed a high credit risk
provide surety bonds or other guarantees of payment.
Audit Statement: The Lottery should revoke the licenses of retailers who fail to meet
minimum sales levels for on-line and instant ticket sales as required by its administrative
rules.
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ As a public agency, the Lottery is governed by procedures and entities that can
contrast with normally accepted private sector business practices. This conflict is
most evident in the Lotteries relationship with its retailer network. The partnership
has been strained by attempts to recoup operating expenses by increasingretailer
costs or impacting their revenue. At the same time, the Lottery has a fiduciary
responsibility to the state that dictates many of our business practices. Therefore,
it is within this context that the findings outlined by the Auditor General should be
viewed.
As the Auditor General noted, the Lottery has not been successful in collecting past
due amounts from some retailers. Much of the problem has been out of the Lottery=s
direct control. In FY 1995, the Lottery=s total sales were $258.8 million for the year.
At the end of 1995, total monies not collected from retailers were$199,000. This
represented less than 1/10 of 1% of total sales for that year.
In FY 1996, the situation dramatically worsened because the new on-line vendor,
AWI, was unable to invoice for Scratcher sales from November 1, 1995 through
February 3, 1996. Scratcher sales for the period were estimated to be $30 million.
The Lottery could not document the total due to many retailers= satisfaction, and
uncollected monies in FY 1996 soared to almost $700,000. AWI=s failure to provide
a functional system put tremendous pressure on an already overburdened
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 5
Finding II Recommendations (continued):
Accounting Division, which an earlier audit by Deloitte-Touche identified as being
understaffed. The Lottery=s partnership with retailers was severely strained; political
and public pressure thwarted attempts to continue the collection process.
In March 1997 the Lottery resumed the effort to collect past due amounts. Licenses
have been suspended or revoked for non-responsive retailers, and $214,000 has
already been collected. In April the Lottery enrolled in the Department of Revenue=s
debt setoff program, intercepting tax refunds from individual retailers. Although this
does not apply to corporations or limited-liability retailers, sole proprietors and
partnerships refunds can be intercepted.
A full time collections position has been created in the Accounting Division. The
Security Division has implemented guidelines to determine a retailer=s credit
worthiness, and a surety bond requirement for high-risk retailers. These steps give
the Lottery a stronger position in limiting uncollectible amounts in the future.
$ A second concern of the Auditor General is the Lottery=s reluctance to enforce
minimum sales requirements. Since the Lottery=s inception in 1981, retailers have
resisted the idea of minimum requirements. Their logic is based on several issues:
1. Small >mom and pop= stores can=t match chain resources--or the resulting sales;
thus the requirement is not fair.
2. Location, especially in sparsely-populated rural locations, may limit sales.
Removing the retailer location based solely on minimum sales may eliminate the
area=s only location for Lottery products.
3. Chain stores should be treated as a single entity, with sales averaged across the
chain to ensure all locations meet the minimum.
Because requirements have not been enforced in the past, retailers assume they
never will be. Chain stores, which account for 80% of our sales, are adamant in
their desire to advertise Lottery products at all their locations--not just the ones
meeting minimum requirements. The reaction to enforcing this policy will be vocal;
the Lottery anticipates considerable political and public pressure as a result.
Audit Statement: The Lottery should improve internal controls to safeguard cash on hand
and inventories, and access to vaults should be limited. The Lottery should also ensure
that fund and vault balances are not excessive.
Audit Statement: The Lottery should review its management of the revolving fund,
including more frequent reconciliations. Further, the revolving funds balance should be
consistent with the Lottery=s actual needs.
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 6
Finding III Recommendations:
Audit Statement: The Lottery should emphasize job-specific and internal control training
for all employees. Adequate oversight should be provided to ensure procedures are
consistently followed.
Audit Statement: The Lottery should ensure that adequate policies and procedures are
developed regarding all aspects of internal controls, particularly those relating to cash-handling,
inventory, and segregation of duties.
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ The Lottery agrees that its internal controls can be improved. Since January, the
Lottery has been developing policies and working with staff to correct all the
deficiencies noted in the Auditor General=s report. The Lottery requested that the
General Accounting Office perform a financial audit of the Lottery last January in
order to properly address financial internal controls.
$ When the Auditor General cites that cash is not protected, it is referring to one store
located at the Lottery=s headquarters in Tucson. The report gives the impression
that a Ahigh volume@ of the Lottery=s cash is unprotected, and this is not true. That
store holds an average balance of $20,000. The Auditor General did not cite any
problems with the Phoenix store. Overall, the Lottery has cash over $20 million, in
addition to the small amounts in the two stores, that it is managing well.
More importantly, the Lottery disagrees that the cash is left unprotected.
Alltransactions must be recorded in a vault log book. The vault is on day lock during
operating hours, where only the supervisor, or the assistant when the supervisor is
absent, has the key. All employees must sign the log book when using the key.
$ The Lottery respectfully disagrees that there is a lack of control over the revolving
fund. To access the revolving fund, a purchase request must be completed, stating
the reason for the expenditure, requiring the signature of a supervisor and the
division=s Director. The revolving fund custodian reviews and approves the
request. If the request is approved, the custodian normally informs the Director of
Administration of the expenditure. If the request is above $250, the Lottery requires
two signatures on the check before it is released. Finally, the Auditor General was
aware of the $4,600 balance discrepancy because the Lottery reported it as a
reconciling item in our FY 1996 reconciliation. The shortage was due to an
accumulation of unreimbursed expenses dating back to FY 1992. The Lottery is
following the GAO audit recommendation that the Lottery prepare a letter to GAO
and request reimbursement for the unreconciled amount.
$ The Lottery acknowledges improvement is needed in the segregation of duties for
its Lottery store employees. However, it is difficult to limit access of a cash drawer
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 7
Finding III Recommendations (continued):
(the store has two) to one employee. To reconcile the cash drawer, cash, ticket
sales and prize redemptions must be balanced. The Lottery store has two terminals
and two ticket dispenser bins. It is logistically not practical for each employee to
have a separate on-line terminal and a set of scratcher tickets (minimum of 12
games) at their disposal. Employees must be relieved for lunches, breaks, etc., and
it is not feasible to stop business and reconcile while customers are waiting. We do,
however, limit the number of employees working the counter to the same two
persons all day, except for lunches and breaks. For security purposes, the Phoenix
store has two video cameras. One is positioned to monitor the cash drawers and
one to monitor employees and customers at the window.
Vault cash reconciliation is done quarterly by Internal Audit, and sometimes weekly
by the Lottery store supervisor. The set up of the daily cash drawer is done by the
assistant.
$ The Auditor General referenced that access to AFIS to enter new vendor
information and release payments for processing could lead to fraudulent activity.
However, according to AFIS Security, the only restriction is that employees may not
input vendor information, release claims and pick up warrants. We are in this
compliance with this requirement. However, one employee as referred to by the
Auditor General, does receive the warrants after pickup. The Lottery will change
this procedure immediately. The Lottery plans to further separate these duties as
recommended when we are fully staffed.
$ The Lottery respectfully disagrees that payroll is not checked. The Lottery has a
written manual detailing payroll procedures. All Lottery calculations are checked by
the Accounting Manager. Internal Audit checks the payroll for every final payoff and
conducts quarterly audits. However, as an extra precaution, payroll staff will
periodically check calculations of employee wages done by DOA personnel using
a random sample.
Response: The Lottery agrees to improve its internal controls for the Lottery store
and promotional inventories. Whereas the Lottery does not believe the vault cash on
hand is excessive, we will review the balance and reduce it accordingly.
$ The Lottery will reduce its revolving fund balance to $10,000 but will maintain its
authorization at $30,000 to cover emergencies.
$ The Lottery will improve its internal control for all employees by providing more
training and oversight to employees.
$ The Lottery will review and update its manuals relating to internal controls, inventory
and segregation of duties.
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 8
Finding III Recommendations (continued):
Audit Statement: The Lottery=s internal audit unit should conduct more audits, including
adherence to policies and procedures, internal control compliance, and review of Lottery
contracts and payments to vendors. The unit should give special attention to the Lottery=s
advertising contract, which involves millions of dollars each year and which has a history
of problems and poor oversight.
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ In February of 1996, the Lottery implemented a revised audit plan which includes
a monthly audit of the advertising contract and invoices received from the
advertising agency. Due to past staffing problems, the Lottery was never able to
fully adhere to internal control compliance. We have since hired an Audit Manager
to ensure compliance that is recommended by the Auditor General.
Additional Comments
Prizes and promotional items mismanaged. In the past, the Lottery inventory systems
have lacked adequate supervision. Steps have been implemented to ensure proper
controls of prizes and promotional items. This includes monthly inventory reports, a sign
out sheet, as well as a new limited access locked promotional cage. We feel that these
safeguards will ensure proper control over prize and promotional item distribution.
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97 9
Finding IV Recommendations:
Audit Statement: The Lottery should develop and distribute written policies and
procedures regarding its computer system.
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ The Lottery will publish existing policies and procedures for users. Training
sessions for appropriate use of the system will be incorporated into the new system
migration scheduled for mid-1998.
Audit Statement: The Lottery should improve security on its computer system by:
a. Reviewing access to the system to ensure employees= access rights are
appropriate to the duties they perform;
Response: The finding of the Auditor General is agreed to and the audit recommendation
will be implemented.
$ MIS staff will review access for current employees, and determine appropriate levels
for new employees.
b. Removing software from its applications package, which gives all employees the
ability to download, alter, and upload data regardless of user access rights; and
Response: The finding of the Auditor General is not agreed to and the recommendation
will not be implemented.
$ All employees do not have the ability to perform these functions; security at the file
level severely limits the potential for data manipulation. As the new application
version is installed, the option to transfer files will not be routinely installed. The
ability does not exist at the current version level.
c. Consolidating its computer systems= security and administration into a single
staff position.
Response: The finding of the Auditor General is agreed to and a different method of
dealing with the finding will be implemented.
$ Current staffing levels do not permit this solution. MIS will attempt to restrict high-level
functions to a limited number of staff; we will involve internal audit in
developing an oversight process for these functions.
Finding IV Recommendations (continued):
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97
10
Audit Statement: The Lottery should enhance its computer system to address problems
associated with disruptions by:
a. Installing a backup, or redundant, processor on its computer system;
b. Testing and revising the disaster recovery plan; and
c. Installing a second high-speed data line between the Lottery and its
contractor.
Response: The findings of the Auditor General are agreed to and the audit
recommendation will be implemented.
$ A separate, redundant system has been purchased and should be installed by year
end.
$ A comprehensive disaster recovery plan will be developed once the redundant
system is installed. Routine testing will be an element of the plan.
$ A second ISDN line will be supplied by the Lottery=s new contractor in mid-1998.
PERFORMANCE AUDIT/SUNSET REVIEW RESPONSES
Arizona Lottery
10/17/97
11
Sunset Factors:
Audit General Finding 4. The extent to which rules and regulations promulgated by the
Lottery are consistent with the Legislative mandate.
Response: The finding of the Auditor General is not agreed to but the recommendation
will be implemented.
The Lottery does in fact have written procedures for the Setoff program. The form for
agency participation in the program is a part of the procedures.
The license requirement is a part of the Retailer rules. They have not yet been adopted.
A.R.S. 5-512(G) states ?A licensed agent shall display his license or a copy of the license
conspicuously in accordance with the rules prescribed by the director.@ The Lottery
determined that this statute was sufficiently clear such that no rule was needed to inform
the licensee of the required action. Because the reference to rules is unnecessary, the
Lottery intends to delete ?in accordance with the rules prescribed by the director@ from this
statute during the upcoming legislative session as part of technical amendments to the
Lottery statutes.
With the passage of A.R.S. 41-1092 et seq. (Creating the Office of Administrative Hearings
and prescribing procedures for administrative hearings), the Lottery=s rules concerning
administrative hearings became void. Since statutes take precedence over rules, 41-1092
and not the Lottery rules, governs the administrative hearing process. The Lottery=s
revised retailer rules incorporate 41-1092 and therefore fully comply with all current case
laws and statutes. The revised rules are in the final process of being enacted.