CFE Exam Quiz 54

Conspiracy refers to a situation in which two or more people agree to commit an illegal act. In most jurisdictions, the crime of conspiracy is actually a separate criminal offense from the underlying crime, meaning that the underlying crime (e.g., bank fraud, bribery, securities fraud, etc.) and the conspiracy to commit it are two separate offenses.

An action for fraud may be based on the concealment of material facts, but only if the defendant had a duty in the circumstances to disclose. The essential elements of fraud based on the failure to disclose material facts are:

• The defendant had knowledge of a material fact.
• The defendant had a duty to disclose the material fact.
• The defendant failed to disclose the material fact.
• The defendant acted with the intent to mislead or deceive the victim(s).

Generally, the specific elements required to establish a negligent misrepresentation claim are as follows:

• The defendant made a misrepresentation of a material fact.
• The misrepresentation was made pursuant to a special relationship that imposed a duty on the defendant to provide correct information.
• The defendant had no reasonable basis to believe the misrepresentation to be true.
• The victim relied on the misrepresentation, and the reliance was reasonable.
• The victim suffered damages as a result.

Internal Controls:

Management must also analyze their organization’s internal controls and enhance them as necessary to eliminate procurement risks. Key internal controls include, but are not limited to:

• Separation of duties
• Supervisory controls
• Receiving controls
• Authorization/approval controls
• Reconciliation controls
• Recording controls

Vendor management should include, among other things:

• Vendor background checks
• Controls for vendor master file management
• Vendor monitoring

Labor mischarges can be detected by engaging in the following activities:

• Examine labor cost records for the presence of red flags.
• Review audit reports, reimbursement requests, construction reports, engineering reports, and so on.
• Conduct site visits to verify that selected employees’ labor costs are being properly charged to the work actually being performed.
• Examine time cards and total the hours expended on the contract, comparing them to the hours billed.
• Note, in particular, repeated instances or a pattern of labor charges that increase the cost of cost-plus contracts.
• Review journal entries used to transfer labor costs.
• Compare labor costs over a specific period to identify any unusual changes and determine the reason for the changes.
• Review the standard and actual labor rates to determine if there are any significant differences between the two.
• Calculate the percentage of total direct labor charged to each contract to determine which had the highest percentage of direct labor charges.
• Review and compare the labor distribution summaries with payroll records to determine whether the total labor distributions agree with the total labor charges.
• Compare the direct and indirect labor account totals from the prior year to the current year and note the percentage change.

Common red flags of labor cost mischarging schemes include:

• Billings not in line with estimates
• Excessive or unusual labor charges
• Sudden, significant shifts in labor charge levels- Labor charges inconsistent with contract progress
• Vague or minimal education, credential, and experience qualification requirements for labor-hour contract positions
• Procuring entity personnel who do not review or challenge qualifications of key contractor employees
• The contractor has a high employee turnover rate among procurement personnel
• The contractor must hire large numbers of personnel quickly- Contractor personnel rarely take a vacation
• Significant increases in charges to overhead accounts (e.g., idle time, downtime, and non-applied time)
• The contractor with a mix of cost-type and fixed-price contracts
• Increased labor hours with no corresponding increases in the material used or units shipped

Labor costs are made up of direct labor charges to the contract and indirect labor charges allocated to the contract through a factor or rate. Direct labor charges are contract costs identified specifically with a contract. In general, direct labor costs are calculated by multiplying all project hours with the labor rates, which are based on actual employee wages or represent wages paid, and they are summarized for all employees within the applicable allocation unit. Indirect labor costs are those identified in two or more cost objectives.

Material mischarges can be detected by engaging in the following activities:

• Examine contract and cost files for red flags.
• Examine material cost transfers, which can include transfers:
• From government contracts to commercial
• Through any type of suspense or holding account
• From ongoing jobs to jobs not scheduled for delivery until a much later date
• From prior lot work orders to current or future work orders
• To inventory write-off accounts
• To scrap accounts

ACCOUNTING MISCHARGES

Accounting mischarges occur when a contractor knowingly charges unallowable costs to the buyer by concealing or misrepresenting them as allowable costs, or by hiding them in accounts, such as office supplies, that are not usually closely audited. A variation of this type of scheme involves circumventing the limits for certain cost categories by charging those expenses to other cost categories that do not have such limits. For example, a contractor might charge bid and proposal costs or independent research and development costs, which are usually cost-based but limited to a fixed amount, to salaries and wages, repairs and maintenance, or other cost categories.

Here are some common methods contractors use to mischarge costs:

• Charging the same cost to more than one contract
• Charging nonexistent costs or costs at inflated amounts
• Charging unallowable costs (e.g., entertainment or advertising) to the contract
• Charging costs to the wrong category or contract
• Failing to disclose discounts and credits
• Using outdated standard costs

RED FLAGS OF CHANGE ORDER ABUSE

When a change order occurs, fraud examiners should immediately be concerned about whether the change was accidental or planned. The following list of red flags can help make this determination.

• Poor contractor internal controls over determining the need for change orders (e.g., management officials fail to ensure that all proposed change orders are necessary for work that was not known or contemplated at the time the contract was awarded)
• Procurement employee acts outside the normal scope of duties
• Numerous change orders justified on a variety of grounds, including alleged change in prices, inflation, unavailability of specific materials or equipment, and the need to substitute more expensive alternatives
• An employee of procuring entity approves numerous unexplained or unjustified change orders for the same contractor
• A repeated pattern of change orders that increases the price, scope, or period of an agreement, issued after the procuring entity awards the contract
• Questionable, undocumented, or frequent change orders awarded to a particular contractor
• After a contract is awarded, bid specifications that lack detail (the requirements are vague) are clarified by issuing a change order
• Poorly drafted requests for change orders

Additionally, to detect nonconforming schemes, the fraud examiner should:

• Review correspondence and contract files for indications of noncompliance.
• Request assistance from outside technical personnel to conduct after-the-fact tests.
• Inspect or test questioned goods or materials by examining packaging, appearance, and description to determine if the items are appropriate.
• Segregate and identify the source of the suspect goods or materials.
• Review inspection reports to determine whether the work performed and materials used in a project were inspected and considered acceptable.
• Review the contractor’s books, payroll, and expense records to see if they incurred the necessary costs to comply with contract specifications.
• Review the inspection and testing reports of questioned goods or materials.

RED FLAGS OF NONCONFORMING GOODS OR SERVICES SCHEMES

The following is a list of potential red flags for nonconforming schemes:

• A high percentage of returns for noncompliance with specifications
• Missing, altered, or modified product compliance certificate
• Compliance certificates signed by employees with no quality assurance responsibilities- Materials testing done by the supplier, using the supplier’s own personnel and facilities
• Evidence that test or inspection results were falsified (e.g., documents appear altered or modified, test documents are illegible, signatures on documents are illegible, documents were signed by unqualified or inappropriate personnel, test reports are similar or identical to sample descriptions and test results, and so on)
• Highest profit product lines have the highest number of material return authorizations or reshipments

Nonconforming Goods or Services

Nonconforming goods or services fraud, also known as product substitution or failure to meet contract specifications, refers to attempts by contractors to deliver goods or services to the procuring entity that do not conform to the underlying contract specifications. Once contractors deliver goods that do not conform to the contract, the bill and receive payment for conforming goods or services without informing the purchaser of the deficiency.

These schemes can involve a wide variety of conduct, but generally, they include any deliberate departures from contract requirements to increase profits or comply with contract time schedules.

An unintentional failure to meet contract specifications is not fraud, but it might constitute a breach of contract. But a contractor who knowingly delivers goods or services that do not meet specifications might be guilty of fraud if he falsely represents that he has complied with the contract or deliberately conceals his failure to do so.

PRETEXTING

Pretexting is the act of impersonating someone else or making false or misleading statements to persuade a target to release information or perform some action. Pretexting can occur in person, over the phone, or through some other form of communication.

Social engineers often engage in pretexting by posing as a person of authority, a member of tech support, someone who has legitimate access to the target’s network, an individual who needs help, a government employee, and so on.

For further clarification, consider how open-source information differs from nonpublic information. The dividing line between open-source information and other, nonpublic information (such as trade secrets) is the right to access it. Open-source information is available to anyone who wants to collect it, without legal consequences. Nonpublic information, however, is not open to the public. Access to nonpublic records is restricted. Obtaining nonpublic records without appropriate authority violates the law.

Open-Source Information

Open-source information is information in the public domain; according to the U.S. National Open Source Enterprise’s Intelligence Community Directive Number 301, it can be defined as publicly available data “that anyone can lawfully obtain by request, purchase, or observation.”1 Open-source information can include

• Mass media communications (e.g., Internet publications, newspaper or magazine articles, radio or television broadcasts)- Computer-based information
• Public information that a governmental body must maintain and make accessible to the public- Information derived from professional and academic sources
• Commercial data

Generally, a nondisclosure agreement is a written agreement providing that signatory employees 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.

A noncompetition agreement is an agreement whereby one party (usually an employee) agrees not to work for or start a company in competition against another party (usually the employer) within a certain period. Such agreements usually take effect after the employer-employee relationship has ended.

• The agreement is supported by consideration at the time it is signed. If the employment agreement and the noncompetition agreement are signed at the same time (or if the noncompetition agreement is signed before the employee begins employment), the employment itself will be sufficient consideration for the promise not to compete. If however, an employee signs the noncompetition agreement after beginning employment, the agreement generally will be invalid unless the employee receives something of value (besides the promise of continued employment) in exchange for the promise (e.g., promotion or additional benefit that was not part of the original employment agreement).
• The agreement protects a legitimate business interest of the employer (e.g., confidential information and goodwill developed by an employer in terms of customer relations).
• The agreement is reasonable in scope, geography, and duration. Courts generally only enforce noncompetition agreements to the extent necessary to protect the employer. Thus, to be enforceable, such agreements must contain reasonable limitations to the scope, geographical area, and time in which a party may not compete.

CIVIL ACTION FOR MISAPPROPRIATION OF TRADE SECRETS

In most jurisdictions, a victim of trade secret theft may file a civil action for damages or request an injunction—a court order by which a party is required to perform, or is restrained from performing, a specific act—under various types of laws. Civil damages for misappropriation of trade secrets might include reimbursement for actual losses caused by the defendant, such as lost profits, reimbursement of development expenses and overhead costs, and the cost of efforts to protect the secret or recover damages, as well as for reduction in the value of the business. Damages also can be measured by the defendant’s profits, which may be ordered to be paid to the plaintiff. Punitive damages and attorney’s fees also may be awarded.

In addition to or in lieu of monetary damages, the plaintiff in a civil action for misappropriation of trade secrets also may obtain an injunction prohibiting further use of the information. But injunctions are difficult to obtain. To obtain an injunction, the plaintiff must establish that an injunction is warranted.

Generally, to demonstrate that an injunction is warranted, the plaintiff must establish that:

• The plaintiff is the proper owner of the trade secret.
• An unauthorized person has taken or used the trade secret.
• There is a high probability of improper disclosure.
• The injunction is necessary to prevent the plaintiff from suffering immediate and irreparable harm that cannot be adequately compensated by monetary damages.
• The plaintiff probably will win the underlying case for misappropriation of trade secrets.

Jurisdictions might have several criminal obstruction statutes.

Some common types of obstruction statutes are those that prohibit:

• Influencing or injuring any officer of the court or juror by force, threats of force, intimidating communications, or corrupt influence
• Influencing a juror through a writing
• Stealing or altering records or processes by parties that are not privy to the records
• Using force or threats of force to obstruct or interfere with a court order
• Destroying documents related to a future proceeding
• Tampering with a witness, victim, or an informant (e.g., killing or attempting to kill, using force or threats of force, intimidating, influencing with bribes or other corrupt means, misleading, or harassing the protected parties)
• Influencing, obstructing, or impeding a government auditor in the performance of his official duties- Obstructing the examination of a financial institution

In 1995, measures to address the remaining areas of concern were presented in the Revised Recommendation on Combating Bribery in International Business (Revised Recommendation). To strengthen banking and accounting standards, the Revised Recommendation advocates that OECD members take the following steps:

• Prohibit off-book transactions and accounts.
• Require companies to maintain adequate records of income and expenditures and to disclose material contingent liabilities in financial statements.
• Establish and maintain standards to ensure independence when financial statements are audited externally.
• Encourage companies to adopt internal controls and standards of conduct that provide protection and channels for reporting violations.
• Suspend companies that have bribed foreign officials from competing for public contracts.
• Incorporate anti-corruption provisions into bilateral aid-funded procurements and international development institutions.
• Cooperate fully with other countries and international bodies in the investigation and prosecution of bribery cases.

In 2009, the Working Group issued two additional recommendations for further combating bribery of foreign public officials in international business transactions. For the most part, these instruments merely reinforce the earlier Recommendations and OECD Anti-Bribery Convention. They encourage member countries to review, evaluate, and, where necessary, strengthen the laws and regulations relevant to the fight against foreign bribery. Members are specifically advised to re-examine standards pertaining to:

• The adequacy of accounting requirements
• The independence of external audits
• Corporate internal controls and compliance programs
• The suspension of public advantages for enterprises that have engaged in foreign bribery

CRIMINALIZATION

As noted above, the UN Convention addresses all forms of corruption, not bribery alone. The UN Convention lists specific acts of corruption, but it does not require member states to criminalize every one of them. Instead, it requires member states to criminalize only certain acts of corruption and to merely consider criminalizing others. Specifically, members to the UN Convention must establish a criminal offense for the following acts of corruption:

• The supply and demand of bribes to domestic public officials
• The supply of bribes to foreign public officials
• Money laundering
• The embezzlement, misappropriation, or diversion of public property by domestic officials

In practice, the books and records provisions are used to prevent three types of improprieties:

• The failure to record improper transactions
• The falsification of records to conceal improper transactions
• The creation of records that are quantitatively correct, but fail to specify the qualitative aspects of a transaction that might reveal the true purpose of a particular payment

Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange of Information.

In 2002, the International Organization of Securities Commissions (IOSCO), an international organization comprising securities commissioners and administrators responsible for securities regulation and the administration of securities laws in their respective countries, approved a multilateral agreement on cooperation and global information exchange within the international community of securities regulators.

The agreement, known as the Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange of Information (IOSCO MMoU), was the first international standard for cooperation in dealing with breaches of stock exchange regulations.

Core Principles for Effective Banking Supervision

The Core Principles for Effective Banking Supervision is a set of supervisory guidelines the Basel Committee on Banking Supervision developed to provide a general framework for effective banking supervision. That is, they were designed to help countries assess their banking supervisory systems and identify areas for improvement and to promote more consistent and effective bank supervision in all countries. The Core Principles for Effective Banking Supervision also serve as a reference document for national supervisors and international institutions.