CFE Exam Quiz 55

• Maintain accurate and complete internal accounting records.
• Carefully monitor the business transactions and interpersonal relationships of suppliers, buyers, purchasing agents, sales representatives, and others who interface in the transactions between financial units.
• Establish a physical security system to secure company assets, including finished goods, cash, capital equipment, tools, and other valuable items.
• Segregate duties between employees, ensuring that no single individual has total control of one area.
• Maintain accurate personnel records, including background checks (where permitted by law) on new employees.
• Encourage strong supervisory and leadership relationships within groups to ensure enforcement of accounting procedures.

Reduce the Rationalization of Fraud—Strengthen Employee Personal Integrity

• Managers should set an example by promoting honesty in the accounting area. It is important that management practice what it preaches. Dishonest acts by management, even if they are directed at someone outside of the organization, create a dishonest environment that can spread to other business activities and other employees, both internal and external.
• Honest and dishonest behavior should be defined in company policies. Organizational accounting policies should clear up any ambiguity in accounting procedures.
• The consequences of violating the rules, including the punishment of violators, should be clear.

Internal Auditors

Internal auditors are responsible for helping to deter fraud by examining and evaluating the adequacy and effectiveness of controls, along with the extent of the potential exposure in the various segments of an entity’s operations. The internal auditing standards state that the principal mechanism for deterring fraud is internal control. Primary responsibility for establishing and maintaining internal control rests with management. The Treadway Commission addresses this issue by recommending that internal audit departments or staffs have not only the support of top management but also the necessary resources available to carry out their mission. The internal auditors’ responsibility is to aid management in the deterrence of fraud by evaluating the adequacy and effectiveness of the company’s internal control system, as well as the company’s potential exposure to fraud, with particular consideration given to the five elements of internal control laid out by the Committee of Sponsoring Organizations (COSO). The five elements of internal control are discussed in more detail in the Fraud Prevention and Deterrence section of the Fraud Examiners Manual.

External Auditors

External auditors inspect clients’ accounting records and independently express an opinion as to whether financial statements are presented fairly in accordance with the applicable accounting standards of the entity, such as GAAP or IFRS. They must assert whether financial statements are free of material misstatement, whether due to error or fraud.

Independence is the cornerstone of the auditing function. The only way external auditors can uncover and rectify instances of fraud is if they view the financial statements objectively. However, external auditors are not required to uncover all instances of fraud that might be occurring, as this would be a difficult and nearly impossible task.

The responsibilities of the external auditor as they relate to fraud detection are clearly outlined in International Standard on Auditing (ISA) 240, The Auditor’s Responsibility Relating to Fraud in an Audit of Financial Statements. According to this guidance:

the auditor is responsible for maintaining professional skepticism throughout the audit, considering the potential for management override of controls, and recognizing the fact that audit procedures that are effective for detecting error may not be effective in detecting fraud. The requirements in this [standard] are designed to assist the auditor in identifying and assessing the risks of material misstatement due to fraud and in designing procedures to detect such misstatement.

Audited financial statements are examined by a variety of external users, including investors, creditors, and government bodies. These users depend on the integrity of the statements for a variety of decision-making purposes. Therefore, external auditors have a professional obligation to evaluate the financial statements as thoroughly and objectively as possible. Furthermore, if management and the accountants know that external auditors conduct sensible audits, they might be deterred from committing financial statement fraud.

Skimming

Skimming is the removal of cash from a victim entity prior to its entry in an accounting system. Employees who skim from their companies steal sales or receivables before they are recorded in the company books. Skimming schemes are known as off-book frauds, meaning cash is stolen before it is recorded in the victim organization’s accounts. This aspect of skimming schemes means they leave no direct audit trail. Because the stolen funds are never recorded, the victim organization might not be aware that the cash was ever received. Consequently, it can be difficult to detect that the cash has been stolen. This is the primary advantage of a skimming scheme for the fraudster.

Skimming is one of the most common forms of occupational fraud. It can occur at any point where cash enters a business, so almost anyone who deals with the process of receiving cash might be in a position to skim money. This includes salespeople, tellers, waitpersons, and others who receive cash directly from customers.

In addition, many skimming schemes are perpetrated by employees whose duties include receiving and logging payments made by customers through the mail. These employees slip customer payments out of the incoming mail instead of posting the payments to the proper revenue or receivables accounts. Those who deal directly with customers or who handle customer payments are obviously the most likely candidates to skim funds.

Sales Skimming

The most basic skimming scheme occurs when an employee sells goods or services to a customer and collects the customer’s payment, but makes no record of the sale. The employee simply keeps the money received from the customer instead of turning it over to his employer. (See the “Unrecorded Sales” flowchart.)

Skimming Receivables

It is generally more difficult to conceal the skimming of receivables than the skimming of sales because receivables payments are expected. The victim organization knows the customer owes money and it is waiting for the payment to arrive. When unrecorded sales are skimmed, it is as though the sale never existed. But when receivables are skimmed, the absence of the payment appears on the books as a delinquent account. To conceal a skimmed receivable, a perpetrator must somehow account for the payment that was due to the company but never received. There are a number of common techniques fraudsters use to conceal the skimming of receivables.

Receipt Recording

An in-depth analysis of the cash receipts and recording process is the key to detecting a cash larceny scheme.

Areas of analysis might include:

• Mail and register receipt points
• Journalizing and recording of the receipts- Security of the cash from receipt to deposit

Analytical Review

Analyzing the relationship among sales, cost of sales, and the returns and allowances can detect inappropriate refunds and discounts.

• If a large cash fraud is suspected, a thorough review of these accounts might enlighten the fraud examiner as to the magnitude of the suspected fraud.
• An analysis of refunds and returns and allowances with the actual flow of inventory might reveal some fraud schemes. The refund should cause an entry to inventory, even if it is damaged inventory. Likewise, a return will cause a corresponding entry to an inventory account.
• There should be a linear relationship between sales and returns and allowances over a relevant range. Any change in this relationship might point to a fraud scheme unless there is another valid explanation, such as a change in the manufacturing process, change in a product line, or change in price.

Fictitious Refunds or Voided Sales

Fictitious refunds or voided sales can often be detected when closely examining the documentation submitted with the cash receipts.

• One detection method is to evaluate the refunds or discounts given by each cashier or salesperson. This analysis might point out that a single employee or group of employees has a higher incidence of refunds or discounts than others. Further examination is then necessary to determine if the refunds are appropriate and properly documented.
• Signs in the register area asking customers to ask for and examine their receipts employ the customer as part of the internal control system. This helps ensure that the cashier or salesperson is properly accounting for the sale and prevents employees from using customer receipts as support for false void or refunds.
• Random service calls to customers who have returned merchandise or voided sales can be used to verify the legitimacy of transactions.

Bank-Assisted Controls

Companies should work in a cooperative effort with banks to prevent check fraud. Consider the following control measures that might be taken in regard to a firm’s checking accounts.

• Establish maximum amounts above which the company’s bank will not accept checks drawn against the account.
• Use positive pay banking controls. Positive pay allows a company and its bank to work together to detect fraudulent items presented for payment. The company provides the bank with a list of checks and amounts that are written each day. The bank verifies items presented for payment against the company’s list. The bank rejects items that are not on the list. Investigations are conducted as to the origin of the “non-listed” items.

Competitive Negotiation

Competitive negotiation permits bargaining between the procuring entity and prospective contractors before the contract is awarded. Organizations use this process when the cost is not the most important factor of evaluation, and typically when:

• Sealed bids are not appropriate.
• The procuring entity needs to conduct discussions with potential providers because of differences in laws, regulations, or business practices.
• The acquisition is complex or vague.
• The procuring entity cannot accurately determine the risks.
• There is a relatively long, drawn-out production time.
• The procuring entity is contracting for a production effort (and not a specific item for delivery).

Additionally, because sole-source contracting does not provide for full and open competition, organizations that use this form of procurement typically require justification for its use. For example, in the United States, the Federal Acquisition Regulation, the system of regulations that applies to the government’s procurement of goods and services, provides the following seven reasons that can be invoked to justify sole-source contracting:

• Only one responsible source and no other supplies or services will satisfy agency requirements
• Unusual and compelling urgency
• Industrial mobilization; engineering, developmental, or research capability; or expert services- International agreement
• Authorized or required by statute- National security- Public interest

In general, simplified acquisition procedures might include any of the following contracting mechanisms:

• Charge accounts
• Purchasing cards
• Purchase orders
• Petty cash funds

Charge Accounts

Charge accounts are a simplified way for management to meet anticipated, repetitive needs for services and products from trusted suppliers. A charge account is a pre-arranged agreement with an organization that is signed before any business is conducted.

Complementary Bidding

Complementary bidding (also known as a protective, shadow, or cover bidding) occurs when competitors submit token bids that are not serious attempts to win the contract. Token bids give the appearance of genuine bidding, but by submitting token bids, the conspirators can influence the contract price and who is awarded the contract. Often, conspirators in complementary bidding schemes submit token bids that:

• Are too high to be accepted- Appear to be competitive in price but deliberately fail to meet other requirements.
• Contain special terms that will not be acceptable to the buyer.

Bid Rotation

Bid rotation, also known as bid pooling, occurs when two or more contractors conspire to alternate the business among themselves on a rotating basis. Instead of engaging in competitive contracting, the bidders exchange information on contract solicitations to guarantee that each contractor will win a share of the purchasing entity’s business.

Bid Suppression

Bid suppression occurs when two or more contractors enter into an illegal agreement whereby at least one of the conspirators refrains from bidding or withdraws a previously submitted bid. The goal of these schemes is to ensure that a particular competitor’s bid is accepted. Bid suppression schemes, however, can take on other forms. Because many schemes involving collusion among competitors require that a limited number of bidders agree to the conspiracy, price inflation should become apparent if a new or uncooperative bidder enters the competition. To prevent this, conspirators might pay off outside companies to refrain from bidding or withdraw an already submitted bid. Conspirators might also use more forceful means to discourage uncooperative entities from participating in the bidding process. For example, to protect their monopoly, conspirators might fabricate bid protests or coerce suppliers and subcontractors to avoid dealing with non-cooperating companies.

Red Flags of Schemes Involving Collusion Among Contractors

Common red flags of schemes involving collusion among contractors include:

• The industry has limited competition.
• The same contractors bid on each project or product.
• The winning bid appears too high.
• All contractors submit consistently high bids.
• Qualified contractors do not submit bids.
• The winning bidder subcontracts work to one or more losing bidders or to non-bidders.
• Bids appear to be complementary bids by companies unqualified to perform the work.
• Some bids fail to conform to the essential requirements of the solicitation documents (i.e., some bids do not comply with bid specifications).
• Some losing bids were poorly prepared.
• Fewer competitors than usual submit bids on a project or product.
• When a new contractor enters the competition, the bid prices begin to fall.
• There is a rotational pattern to winning bidders (e.g., geographical, customer, job, or type of work).
• There is evidence of collusion in the bids (e.g., bidders make the same mathematical or spelling errors; bids are prepared using the same typeface, handwriting, stationery, or envelope; or competitors submit identical bids).
• There is a pattern where the last party to bid wins the contract.
• There are patterns of conduct by bidders or their employees that suggest the possibility of collusion (e.g., competitors regularly socialize, hold meetings, visit each other’s offices, subcontract with each other, and so on).

Procurement fraud schemes involving the purchasing entity’s contractors and employees generally include the following:

• Need recognition
• Bid tailoring
• Bid manipulation
• Leaking bid data
• Bid splitting
• Unjustified sole
• Source awards or other non-competitive methods of procurement

Other common red flags of need recognition schemes include:

• The assessment of needs is not adequately or accurately developed.
• There is no list of backup suppliers for items, spare parts, and services continually purchased from a single source.
• Estimates are either not prepared or are prepared after solicitations are requested.
• Items, parts, and services are obtained from a single source.
• A suspect employee displays sudden wealth, pays down debts, or lives beyond his means.
• A suspect employee has an outside business.
• Multiple purchases are made that fall below the threshold limit.
• Purchases are made without receiving reports.

Some common red flags of bid tailoring include:

• Weak controls over the bidding process
• Only one or a few bidders respond to bid requests
• The contract is not re-bid even though fewer than the minimum number of bids are received
• The similarity between specifications and winning contractor’s product or services
• Bid specifications and statements of work are tailored to fit the products or capabilities of a single contractor
• Unusual or unreasonably narrow or broad specifications for the type of goods or services being procured
• Requests for bid submissions do not provide clear bid submission information (e.g., no clear time, place, or manner of submitting bids)
• Unexplained changes in contract specifications from previous proposals or similar items
• The high number of competitive awards to one supplier
• Socialization or personal contacts among contracting personnel and bidders
• Specifications developed by or in consultation with a contractor who is permitted to compete in the procurement
• High number of change orders for one supplier

Some common ways to commit these schemes to include:

• Using obscure publications to publish bid solicitations
• Publishing bid solicitations during holiday periods
• Accepting late bids or falsifying the bidding log
• Altering bids
• Extending bid opening dates without justification
• Prematurely opening bids
• Releasing confidential information
• Discarding or losing a bid or proposal
• Disqualifying bids for improper reasons (e.g., voiding bids for alleged errors in specifications)
• Adding new vendors to the qualified bidder list for no apparent reason
• Limiting the time for submitting bids so that only those with advance information have adequate time to prepare bids or proposals

Some common red flags of bid manipulation schemes include:

• Weak controls over the bidding procedures are present.
• There is evidence of changes to bids after they were received.
• The winning bid is voided for errors and the job is re-bid or awarded to another contractor.
• An otherwise qualified bidder is disqualified for seemingly arbitrary, false, frivolous, or personal reasons.
• A procurement employee accepts late bids.
• The contract is awarded to a non-responsive bidder.

Some common red flags of leaking bid data schemes include:

• The procuring entity has weak controls over its contracting system.
• The winning bid is just under the next lowest bid.
• The winning bid is unusually close to the procuring entity’s estimates.
• The last party to bid wins the contract.
• The contract is unnecessarily re-bid.
• A contractor submits false documentation to get a late bid accepted.
• Contracting personnel provides information or advice about contracts to a contractor on a preferential basis.

Some common red flags of bid splitting schemes include:

• Two or more similar or identical procurements from the same supplier in amounts just under upper-level review or competitive-bidding limits
• Two or more consecutive related procurements from the same contractor that fall just below the competitive-bidding or upper-level review limits
• Unjustified split purchases that fall under the competitive-bidding or upper-level review limits
• Sequential purchases just under the upper-level review or competitive-bidding limits
• Sequential purchases under the upper-level review or competitive-bidding limits that are followed by change orders

Some common red flags of unjustified sole-source award schemes include:

• Frequent use of sole
• Source procurement contracts- High number of sole
• Source awards to one supplier
• Requests for sole-source procurements when there is an available pool of contractors to compete for the contract
• Procuring entity did not keep accurate minutes of pre-bid meetings
• False statements made to justify the non-competitive method of procurement
• Justifications for noncompetitive method signed or approved by employees without authority
• The employee fails to obtain the required review for sole-source justifications
• Sole-source justifications developed by or in consultation with a contractor who is permitted to compete in the procurement

Methods of Defective Pricing

A contractor can use various defective pricing schemes to increase the cost of the contract and thereby its profits, but generally, defective pricing schemes involve inflated labor costs or inflated material costs. A contractor can inflate labor costs by:

• Using outdated cost schedules
• Using lower-wage personnel to perform work at higher rates
• Using salaried personnel to perform uncompensated overtime
• Failing to account for learning
• Curve cost reductions
• Subcontracting to affiliated companies at inflated rates

A contractor can inflate material costs by:

• Failing to disclose discounts and credits
• Using outdated standard costs
• Using small-quantity costs to price large quantity purchases
• Subcontracting to or purchasing from affiliated companies at inflated prices
• Failing to disclose residual materials inventory
• Using phantom suppliers to inflate costs
• Failing to disclose changes in “make or buy” decisions
• Estimating costs based on invalid cost allocation methods
• Using unsupported cost escalation factors