CFE Exam Quiz 03

Corruption is a term used to describe various types of wrongful acts designed to cause an unfair advantage. It can take on many forms, including bribery, kickbacks, illegal gratuities, economic extortion, and collusion. Generally, it involves the wrongful use of influence to procure a benefit for the actor or another person, contrary to the duty or the rights of others. The various forms of corruption are often used in combination, which reinforces the schemes’ potency and makes them more difficult to combat. Corruption can be found in any business or organization, and it is one of the three major categories of occupational fraud and abuse (along with asset misappropriation and fraudulent statements). The most common area for corruption in an organization is in the purchasing environment, and most corruption schemes involve employees acting alone or in collusion with vendors/contractors. Corruption is a significant problem for organizations, particularly due to the drive for growth in international markets. Despite the multitude of anti-corruption legislation and increased enforcement efforts around the world, corruption is still prevalent.

Bribery may be defined as the offering, giving, receiving, or soliciting of corrupt payments (i.e., items of value paid to procure a benefit contrary to the rights of others) to influence an official act or business decision. For a detailed discussion of the legal elements of bribery and corruption, please see the Law section of the Fraud Examiners Manual. At its heart, a bribe is a business transaction, albeit an illegal or unethical one. A person “buys” influence over the recipient of the bribe to procure a benefit that is contrary to the duty or the rights of others. Bribery schemes can be difficult to detect. In the employment context, bribery involves a conflict of interest in which the employee’s personal interest overwhelms his professional responsibilities. Though bribery schemes are not nearly as common as other forms of occupational fraud, such as asset misappropriations, they tend to be much more costly.

Bribery often takes the form of kickbacks, a form of negotiated bribery in which a commission is paid to the bribe-taker in exchange for the services rendered. Thus, kickbacks are improper, undisclosed payments made to obtain favorable treatment. In the government setting, kickbacks refer to the giving or receiving anything of value to obtain or reward favorable treatment in relation to a government contract. In the commercial sense, kickbacks refer to the giving or receiving anything of value to influence a business decision without the employer’s knowledge and consent.

In most instances, kickback schemes involve overbilling. In these schemes, a vendor submits inflated invoices to the victim organization, and the false invoices either overstate the cost of actual goods and services or reflect fictitious sales. To ensure that the inflated invoices get approved, the corrupt vendor offers kickbacks to an employee of the victim organization who has the authority to approve payment of the fraudulent invoices. By enlisting the help of an employee with such authority, the corrupt vendor ensures that the invoices will be paid without undue hassles. The ability of the employee to authorize purchases, including the ability to authorize fraudulent purchases, is usually a key to kickback schemes. If the fraudster can authorize payments himself, he does not have to submit purchase requisitions to a superior who might question the transaction’s validity.

While the majority of kickback schemes involve individuals with authority to approve purchases, this authority is not an absolute necessity. When an employee cannot approve fraudulent purchases himself, he can still orchestrate a kickback scheme if the employee can circumvent accounts payable controls. In some cases, he can do this by filing a false purchase requisition. If a trusted employee tells his superior that the company needs certain materials or services, this is sometimes sufficient to get a false invoice approved for payment. Such schemes are generally successful when the person with approval authority is inattentive or is forced to rely on his subordinate’s guidance in purchasing matters. Corrupt employees might also prepare false vouchers to make fraudulent invoices appear legitimate. Where proper controls are in place, a completed voucher is required before accounts payable will pay an invoice. To do this, the fraudster must create a purchase order that corresponds with the vendor’s fraudulent invoice. The fraudster might forge the signature of an authorized party on the purchase order to show that the acquisition has been approved. If the company’s payables system is computerized, an employee with access can enter the system and authorize payments on fraudulent invoices.

Kickbacks are not always paid to employees to process phony invoices. Some outsiders seek other fraudulent assistance from employees of the victim organization. For instance, inspectors are sometimes paid off to accept substandard materials or to accept short shipments of goods. Representatives of companies wishing to purchase goods or services from the victim organization at unauthorized discounts sometimes bribe employees with billing authority.
The corrupt employees make sales to their accomplices at greatly reduced ratessometimes even selling items at a lossand in return, they receive a portion of the discount.

Illegal gratuities are items of value given to reward a decision, often after the recipient has made the decision. Illegal gratuities are similar to bribery schemes except that, unlike bribery schemes, illegal gratuity schemes do not necessarily involve an intent to influence a particular
decision before the fact. That is, an illegal gratuity occurs when an item of value is given for, or because of, some act. Often, an illegal gratuity is merely something that a party who has benefited from a decision offers as a “thank you” to the person who made the beneficial
decision. At first glance, it might seem that illegal gratuities schemes are harmless as long as the business decisions in question are not influenced by the promise of payment. But most organizations’ ethics policies forbid employees from accepting unreported gifts from vendors. One reason for such blanket prohibitions is that illegal gratuities schemes can (and do) evolve into bribery schemes. Once an employee has been rewarded for an act such as
directing business to a particular supplier, he might reach an understanding with the gift giver that future decisions will also be made to benefit the gift giver. Additionally, even though no outright promise of payment has been made in an illegal gratuity, employees might direct business to certain companies in the hope that they will be rewarded with
money or gifts.

To be effective, a system for safeguarding sensitive and proprietary information should include the following:
• Taskforce
• Security risk assessments
• Security policies and procedures
• Awareness training
• Nondisclosure agreements
• Noncompetition agreements
• Data classification
• Data retention and destruction policies
• Data minimization
• Security controls
• Measures to guard manual file systems
• Monitoring of visitor access
• Quiet room

To coordinate a company-wide program for safeguarding proprietary information, management should establish a task force and charge it with developing the program. The task force should include managers and staff from departments that deal with proprietary information, such as research and development and production. The task force should also include representatives from the following departments: corporate security, human resources, records management, data processing, and legal. Once the task force is assembled, it must identify the information that is to be protected. To make this determination, the task force should identify those areas that give the company its competitive edge (e.g., quality of the product, service, price, manufacturing technology, marketing, and distribution). When doing so, the task force should ask, “What information would a competitor like to know?” Once the proprietary information has been identified, the task force should focus on the information security procedures for each department. That is, the task force should identify where proprietary information is kept and survey the risk if such information was lost to a competitor.

Educating employees is a key part of preventing data from being compromised. Thus, management should give all personnel awareness training so that they know their role in furthering security. Organizations should strive to make sure that employees understand the importance of information and data security and are trained to protect sensitive information, and they should ensure that employees at satellite offices, temporary help, seasonal workers,
contractors, and vendors are included in the training. Employees must be educated about what information is proprietary. It is difficult to protect
information if no one knows that it needs protecting. For example, employees might know that their employer’s secret formula is proprietary, but they might not know that certain topics of discussion are trade secrets that would be valuable to competitors.

Employees traveling out of the country should be especially knowledgeable about security controls. Many foreign governments operate huge and sophisticated intelligence-gathering operations. Therefore, when traveling abroad, employees should take precautions under the assumption that any mobile electronic devices, such as laptops, mobile phones, and tablets, will be subject to review. The following are some steps an individual can take when traveling abroad:
• Ensure that the software on all devices is patched and up-to-date.
• Password- or passcode-protect all devices.
• Minimize the data contained on any devices.
• Avoid using public computers or connecting to unsecured Wi-Fi.

In short, security awareness training should cover points such as:
• The organization’s information security policies and procedures and the reasons behind
such policies and procedures
• The dangers of data breaches

• Real-world examples of how data has been compromised and what could have been
done to prevent such instances
• Social engineering awareness
• Techniques that hackers use to access sensitive data
• How to avoid phishing attacks
• Appropriate measures for handling and protecting sensitive data
• Techniques for safeguarding portable data
• Password construction and management
• Tips for secure Web browsing
• The appropriate use of social networking sites
• Guidance on data encryption
• Document and data control
• How to recognize security threats
• Procedures for reporting suspected breaches
• Ways to identify and avoid situations that could lead to data breaches
• Guidance on applicable laws
• Disciplinary measures for violating security policies

Management should consider making nondisclosure agreements a mandatory part of their information security programs. Generally, a nondisclosure agreement is a written agreement providing that signatories must keep all trade secrets and proprietary information learned during their employment confidential.
Nondisclosure agreements serve the following functions:
• They delineate the confidentiality expectations the employer has for its employees.
• They demonstrate that the employer is serious about protecting trade secrets and proprietary information.
• They show the reasonable efforts that the employer takes to maintain the secrecy of its confidential information.

External fraud schemes are those committed by outside organizations, typically by individuals or groups of individuals against organizations. Fraud schemes committed by outsiders usually occur within specific industries. Therefore, the following chapters are organized by type of industry, starting with financial institution frauds. Because some schemes are committed by collusion between an organizational insider and an outsider, some frauds can be classified as both internal and external schemes. Financial institutions include banks, savings and loans, credit unions, and other governmentally insured repositories. Financial institution fraud is also known by the more generic term of bank fraud. Check fraud and credit card fraud, as applied to both merchants and financial institutions, are discussed in the “Payment Fraud” chapter. A bank is defined as an organization engaged in any or all of many financial functions, such as receiving, collecting, transferring, paying, lending, investing, dealing, exchanging, and servicing (via safe deposit, custodianship, agency, or trusteeship) money and claims to money, both domestically and internationally.

There are several types of suspense accounts at financial institutions that fraudsters might use, including:
• Loans in process
• Interdepartmental transfers
• Currency in transit
• Refunds on insufficient funds charges
• Due from banks

Persons with apparent authority create journal entries or transfer orders not initiated by customers to move money among accounts. The accounts used are typically dormant or inactive accounts, which are those accounts that show little or no activity. Often, contact with the account holder by confirmation, letter, or telephone is not possible. Such accounts are to be transferred to dual control and recorded in an inactive accounts ledger.
Dormant funds are highly susceptible to embezzlement. The rationale is that funds embezzled from active accounts are likely to be missed quickly, while dormant account holders are less likely to report problems. Many financial institutions lock dormant accounts after a certain time period (e.g., one year of inactivity), requiring manual override to conduct additional transactions. However, this process can be manipulated. Typically, the perpetrator
first identifies accounts that are or are about to be dormant. Next, he might somehow manipulate the account to make it appear that it is not dormant, such as by creating a nominal and fictitious transaction. Then, the employee creates journal entries or transfer orders to move the funds into an account that the employee controls (often a shell organization).

The following are common red flags in source documents that might indicate that embezzlement has occurred:
• Missing source documents
• Payees on source documents (e.g., checks) do not match entries in the general ledger
• Receipts or invoices lack professional quality
• Duplicate payment documents
• Payee identification information that matches an employee’s information or that of his relatives
• Apparent signs of alteration to source documents
• Lack of original source documents (photocopies only)

Some common suspicious items in financial statements are:
• An abnormal increase in accounts receivables that are past due or written off
• Master accounts that do not equal the sum of their individual customer accounts
• Excessive voids or credits
• An abnormal increase in reconciling items

When borrowers approach a lending institution for construction financing, they typically have a development plan, complete with an engineering report, appraisal, and budget for construction costs. The construction cost budget is, by definition, an estimate. As the project is built out, the budget will be revised to reflect actual expenses. Budgets are delineated by specific line items, such as slab, exterior glass, grading, landscaping, and tenant improvements. As the project proceeds, certain over- and under-budget costs are incurred. These costs should be represented by a change order. If the loan agreement has been properly documented and enforced, no material differentiation from the budget should occur without the lender’s knowledge and consent. However, the developer/borrower might misrepresent the true nature of the under- or overbudget amount to mislead the lender. The architect/engineer and the lender’s inspector should examine all budget changes. The impact of change orders might result in the loan becoming out of balance (the cost to complete exceeds available loan and equity funds). Generally, developers hide or conceal their over-budget construction costs in two common places. The first place is contingency and the second is to remove allocations from tenant improvements and apply them to shell construction.

It is not uncommon in construction financing to have a budget line item for developer overhead (also called general conditions). This is a ripe area for abuse. The purpose of developer overhead is to supply the developer with operating capital while the project is under construction. This overhead allocation should not include a profit percentage, as the developer realizes profit upon completion. In essence, the overhead budget is as if the lender is making two types of loans: a real estate loan and a working capital loan for the overhead. Unfortunately, there is seldom, if ever, any separate underwriting for the overhead portion. The overhead is merely added as a construction cost, whose ultimate collateral is the property and not some other short-term collateral. Historically, troubled construction loans or foreclosures due to fraud have been totally disbursed in the developer overhead category.

Generally, a draw request or pay application is made once a month and is verified by a quantity surveyor (QS) or other authorized entity as agreed to by the financial institution. The request should be accompanied by the following documents:
• Paid invoices for raw materials
• Lien releases from each subcontractor
• Inspection reports
• Canceled checks from previous draw requests
• Bank reconciliation for construction draw account for previous month
• Loan balancing form, demonstrating that the loan remains in balance
• Change orders, if applicable
• Wiring instructions, if applicable
• Proof of developer contribution, if applicable

Generally, a draw request or pay application is made once a month and is verified by a quantity surveyor (QS) or other authorized entity as agreed to by the financial institution. The request should be accompanied by the following documents:
• Paid invoices for raw materials
• Lien releases from each subcontractor
• Inspection reports
• Canceled checks from previous draw requests
• Bank reconciliation for construction draw account for previous month
• Loan balancing form, demonstrating that the loan remains in balance
• Change orders, if applicable
• Wiring instructions, if applicable
• Proof of developer contribution, if applicable

Some or all of the following steps should be performed before advancing funds on a construction loan. These steps are not represented as being all-inclusive, but rather the preliminary disbursement questions that the disbursing party should address.
• Examine the draw and determine if sufficient supporting documentation has been submitted.
• Reconcile the amounts requested with the approved budget. Account for any differences.
• Determine that the amounts requested have been properly inspected and approved.
• Determine if the proper lien releases have been submitted for work performed.
• Reconcile any change orders with the approved budget. Determine if the change orders have been approved.
• Prove the clerical accuracy of the documentation submitted.
• Ensure that the work completed has been inspected by the lender’s architect/engineer.
• Determine if there are any requests for soft (non-construction) costs and whether they are appropriate.
• Determine if there are any budget changes. If so, what are they for? Have they been approved?
• Prepare a cost-to-complete estimate to determine that the loan remains in balance.
• If tenant improvement funds have been requested, establish that there is a signed lease on file. Is the request appropriate for the terms and conditions of the lease? Has the lease been approved?
• If homeowner option funds have been requested, establish that there is a signed purchase contract on file. Is the request appropriate for the terms and conditions of the contract? Has the contract/purchaser been approved?
• Examine payment requests and determine if there are new or previously undisclosed subcontractors. If so, determine why.
• Ensure that the title update has been received.

Some or all of the following steps should be performed before advancing funds on a construction loan. These steps are not represented as being all-inclusive, but rather the preliminary disbursement questions that the disbursing party should address.
• Examine the draw and determine if sufficient supporting documentation has been submitted.
• Reconcile the amounts requested with the approved budget. Account for any differences.
• Determine that the amounts requested have been properly inspected and approved.
• Determine if the proper lien releases have been submitted for work performed.
• Reconcile any change orders with the approved budget. Determine if the change orders have been approved.
• Prove the clerical accuracy of the documentation submitted.
• Ensure that the work completed has been inspected by the lender’s architect/engineer.
• Determine if there are any requests for soft (non-construction) costs and whether they are appropriate.
• Determine if there are any budget changes. If so, what are they for? Have they been approved?
• Prepare a cost-to-complete estimate to determine that the loan remains in balance.
• If tenant improvement funds have been requested, establish that there is a signed lease on file. Is the request appropriate for the terms and conditions of the lease? Has the lease been approved?
• If homeowner option funds have been requested, establish that there is a signed purchase contract on file. Is the request appropriate for the terms and conditions of the contract? Has the contract/purchaser been approved?
• Examine payment requests and determine if there are new or previously undisclosed subcontractors. If so, determine why.
• Ensure that the title update has been received.

The final area of major concern in construction lending is retainage (sometimes called the holdback). Retainage is the amount withheld from each draw request until such time as the construction is complete and the lien period has expired. There are at least two reasons why construction loans contain a retainage provision. The first reason is to keep the contractor’s interest in the project until all the work has been completed and accepted by the owner. The amount of the retainage represents a part, if not all, of the contractor’s profit. Therefore, if the profit is not paid until the project has been completed, then presumably the contractor will complete the assignment on time and on budget. The second reason for the retainage is to ensure that the work of subcontractors is completed and that the general contractor pays the subcontractor so that no liens are filed. If the general contractor fails to pay the subcontractor, then the subcontractor will probably file a lien on the project. If the retainage will not be released until such time as the lien period has expired, then there are at least some funds available to defray the cost of fighting the lien or making a duplicate payment because the general contractor might have embezzled the first payment without paying the subcontractor.

The following red flags might identify mortgages containing false or misleading information:
• An item other than cash is used for the down payment (i.e., gift, rent credit, sale of personal property, repayment of a loan)
• Borrower purchasing property from employer or landlord
• The borrower has a non-purchasing spouse
• Borrower purchasing investment property does not own current residence
• The new home is too small for proposed occupants
• The only listing of employer’s address is a post office box
• Borrower, who is purchasing private residence property, has an unreasonable commute from the subject property to his employment
• Borrower’s level of education is inconsistent with employment
• Borrower’s age is inconsistent with the stated employment or the number of years employed
• A borrower is self-employed or his office phone number is the same as his work number
• When compared, borrower’s assets and liabilities are inconsistent
• Buyer is downgrading
• Loan application or appraisal is handwritten or incomplete

The following red flags might identify mortgages containing false or misleading information:
• An item other than cash is used for the down payment (i.e., gift, rent credit, sale of
personal property, repayment of loan)
• Borrower purchasing property from employer or landlord
• Borrower has a non-purchasing spouse
• Borrower purchasing investment property does not own current residence
• New home is too small for proposed occupants
• The only listing of employer’s address is a post office box
• Borrower, who is purchasing private residence property, has an unreasonable commute from the subject property to his employment
• Borrower’s level of education is inconsistent with employment
• Borrower’s age is inconsistent with the stated employment or the number of years employed
• Borrower is self-employed or his office phone number is the same as his work number
• When compared, borrower’s assets and liabilities are inconsistent
• Buyer is downgrading
• Loan application or appraisal is handwritten or incomplete

The narrative form includes all pertinent information about the area and the subject property, as well as the rationale for the estimated value. It includes maps, photographs, charts, and plot plans. Financial institutions use narrative reports to support real estate lending and investment decisions on large commercial real estate transactions. Any other type of appraisal report (i.e., letter form or short form) on these complex transactions would likely be considered inadequate.
1.Determining “Value”
Value is composed of four elements: utility, scarcity, demand, and transferability. Real estate
appraisals assign three types of values to the property. They are as follows.
2.FAIR MARKET VALUE
This is the estimated price the property would bring if freely offered on the open market
with both a willing seller and a willing buyer.
3.SALES PRICE
The sales price is the actual price paid for the property. It might be higher or lower than fair
market value.
4.LOAN VALUE
The loan value is the percentage of a property’s value (fair market value or sales price) a lender
can or might loan a borrower.

The cost approach has five steps:
• Estimate the land value as though vacant and available for development to its highest and best use. (Use the sales comparison approach.)
• Estimate the replacement or reproduction cost of the existing improvements as of the appraisal date.
• Estimate the accrued depreciation amount suffered by the improvements from all causes (physical deterioration and/or functional or external obsolescence).
• Deduct the accrued depreciation from the replacement cost to find the estimate of the value of the depreciated improvements.
• Add the improvements’ depreciated value to the land value to arrive at the value of the property

Fraudulent appraisals result from any number of situations, some of which are:
• Intentional use of an incompetent appraiser
• Giving the appraiser improper or false assumptions to use in arriving at the value, such as:
 Assuming zoning will be changed for a higher and better use when in fact zoning will not be changed
 Assuming unrealistically low vacancy and expense rates (or unrealistically high vacancy and expense rates for a short sale)
 Assuming unrealistically high income, selling prices, or absorption—the rate at which vacant space will become rented
 Otherwise influencing the appraiser—for example, paying an above-market fee or promising future business
 Direct collusion with the appraiser to commit fraud