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CPE for Government Auditors

Fraud Risk Factors a.k.a. the Fraud Triangle

In our last chapter, we discussed the fraud tree – a taxonomy of fraud created by the Certified Fraud Examiners.  Now we are going to look at another model created by the Certified Fraud Examiners which is also mentioned in the GAO’s Green Book – the fraud triangle.

The GAO’s Green Book calls the three components of the fraud triangle ‘fraud risk factors’:

8.04 Management considers fraud risk factors. Fraud risk factors do not necessarily indicate that fraud exists but are often present when fraud occurs. Fraud risk factors include the following:

  • Incentive/pressure - Management or other personnel have an incentive or are under pressure, which provides a motive to commit fraud.
  • Opportunity - Circumstances exist, such as the absence of controls, ineffective controls, or the ability of management to override controls, that provide an opportunity to commit fraud. 
  • Attitude/rationalization - Individuals involved are able to rationalize committing fraud. Some individuals possess an attitude, character, or ethical values that allow them to knowingly and intentionally commit a dishonest act. 

I ‘d seen that triangle dozens of times, but never took it seriously until…

The audit profession underwent a significant transformation in the 90’s.  Auditors acquiesced to customer expectations and agreed to perform some due diligence procedures regarding fraud. So fraud became the training and discussion topic of the moment, and I must have attended over a dozen seminars and read countless articles and books that contained the fraud triangle.  I saw it so often, I started to wonder if it is was any good… kind of like that annoying pop song that you hear 10,000 times each summer. (I swear if I hear “Renegades” one more time, I’m gonna…!  Jeep even uses it to sell Renegades on television commercials!  I can’t escape that song…ARGH. )

But then I sat down to write a book an auditor’s responsibility to detect fraud.  I used the fraud triangle to frame a story about a fraud committed by a close family friend against my uncle and his business.  See the story here in this blog post:  http://yellowbook-cpe.com/my-uncle-and-the-fraud-triangle.html?doing_wp_cron=1471730380.3156929016113281250000

As I wrote that story, I got a sinking feeling that I couldn’t shake.  I suspected that one of my client’s was suffering fraud, too.  Of course, I lacked confidence in my feeling because, once I started writing that book on fraud, I suspected everyone of fraud, even the guy selling pizza slices at the mall!  But when it came to this client, a boutique hotel owner (we’ll call her Jesse), I was actually right.

Jesse, Eowyn and $30,000 in Credit Card Charges

Jesse is very creative and constantly creating super cool venues and experiences for the hip Austin community.  She designed her hotel in Austin with artists and musicians in mind.  Bob Dylan was known to hang out in Jesse’s hotel and as of late, she and her girlfriend have been hanging out with Robert Plant – you know, the lead singer of Led Zepplin.  Soooo cool.

Jesse hired me (unhip and uncool CPA me) to teach her artist-and- musician-employees-turned-business-people how to manage the business’s resources.  As part of this effort, I needed to work closely with her bookkeeper, Eowyn.

Eowyn was so hard to work with that I eventually gave up working for Jesse.  Another reason I stopped working for Jesse is that she was hard to get a hold of.  Jesse was super busy creating other ventures and enjoying her rich social life, and she had left cranky Eowyn in charge.

Eowyn wouldn’t show up for meetings, refused to get me the information I requested, and was aggressive and ornery.  When I asked questions, she was evasive and promised that she’d do some research and get back with me.  She didn’t get back to me. Several times she set a meeting with me that she didn’t bother to attend.

So once, I surprised her and showed up at her office without an appointment.  But instead of giving me what I wanted, she wasted a whole hour telling me all about her sordid personal life.  She told me all about her multiple children and multiple lovers and unemployed ex’s which all sounded like they were living with her and her kids. And although I knew that she was making about $15 an hour and was in her late 20’s, she was sending her two kids to one of the most expensive schools in town.

Eowyn was also very cozy with several other female staff members who were also vaguely unhappy.  Eowyn and her posse were not close to Jesse and her top managers and often made snarky comments to put down the managers. Eowyn and her posse were quick to support each other and shift blame to others for any problem they themselves caused.

And although Jesse offered several times, Eowyn turned down help with her recordkeeping. Eowyn demurred and said she was fine, but looking back, it was obvious she wanted to control the records herself.

How could I have missed it earlier?  Eowyn had every facet of the triangle covered – opportunity, pressure, and justification. Eowyn had the opportunity to steal because Jesse wasn’t watching very closely. She was too busy running her hip and cool empire.  Eowyn definitely had pressure, I mean, supporting a crew of underemployed hipsters and children can’t be cheap!  And although I couldn’t get in Eowyn’s head to figure out how she justified stealing, she might have said something to herself like, “I’m underpaid and Jesse and these managers don’t appreciate me!”

Once I recognized what was going on, I wrote to Jesse (because I could never get her on the phone) and told her to sit down.  I wrote that I suspected Eowyn was stealing from her. She was amazed at my insight because she had just hired an experienced accountant with a background with Marriot hotels who had informed her that Eowyn had taken over $30,000 from Jesse using the hotel’s credit card.

I felt good that I had finally seen it and that I had finally used that suspiciously ubiquitous fraud triangle for a real life situation, but I also felt like a jerk that I had not recognized what Eowyn was up to earlier.  I still feel like a jerk because if I’d ‘clicked’ earlier, I could have saved Jesse $30K.  There Eowyn sat right in front of me, time after time displaying all of the markers of a fraudster – opportunity, pressure, and lots and lots of attitude, and I didn’t see it!

Other clues indicating fraud

So please, take if from me, that silly triangle works.  As does this list of fraud indicators from the State Auditor and Inspector of Oklahoma https://www.sai.ok.gov/Search%20FormsPubs/database/RedFlagsOfFraudHandout.pdf

Common Personality Traits of Fraudsters 

  • Wheeler/Dealer
  • Domineering and Controlling
  • Doesn’t like people reviewing their work
  • Strong desire for personal gain
  • Have a “beat the system” attitude
  • Live beyond their means
  • Close relationship with customers or vendors
  • Unable to relax
  • Often have a “too good to be true” work performance
  • Don’t take leave time or only in small amounts
  • Often work excessive/unnecessary overtime
  • Outwardly appears to be very trustworthy
  • Often display some sort of drastic change in personality or behavior

Common Sources of Pressure 

  • Medical problems – especially for a loved one
  • Unreasonable performance goals
  • Spouse loses a job
  • Divorce
  • Starting a new business or an existing business is struggling
  • Criminal conviction
  • Civil lawsuit
  • Purchase of a new home, second home or remodel
  • Need to maintain a certain lifestyle – Individual or spouse either likes expensive things or feels pressure to “one up” others regarding material possessions.
  • Excessive gambling
  • Drug or alcohol addiction

Changes in Behavior 

  • Suddenly appears to be buying more material items
  • Brags about new purchases
  • Starts carrying large amounts of cash
  • Creditors/bill collectors call or come by work
  • Borrows money from coworkers
  • Becomes more irritable or moody
  • Becomes unreasonably upset when questioned
  • Becomes territorial over their area of responsibility
  • Won’t take leave or only takes leave in small increments
  • Works unneeded/unnecessary overtime
  • Turns down promotions
  • Starts coming in early or staying late
  • Professes need to redo or rewrite work to “make it neat”
  • May begin mentioning family or financial problems
  • Exhibits signs of drug or gambling addiction
  • Exhibits signs of dissatisfaction

Eowyn embodied a good number of those indicators.  Man, I should have paid more attention in those fraud classes!

Defining Corruption per the CFE’s Fraud Tree

More in the series on getting to know the fraud tree better.  To get a better sense of where we are on the fraud tree and which branch we are talking about in this newsletter,  please see the entire fraud tree at http://www.acfe.com/fraud-tree.aspx.

Objectives: 

  • Distinguish between the four major types of corruption and their subcategories

Corruption is the broad title for any behavior on the part of a person in a position of authority to further her own interests, forgetting her responsibilities to the people she serves.  In other words, corruption is when a powerful person acts selfish and greedy. This bad stuff has been going on since the beginning of time!  Was the apple offered by the serpent in the Garden of Eden a bribe?

Corrupt in the dictionary is defined as, “The act of corrupting or making putrid, or state of being corrupt or putrid; decomposition or disorganization, in the process of putrefaction” or “The act of corrupting or of impairing integrity, virtue, or moral principle; the state of being corrupted or debased; loss of purity or integrity; depravity; wickedness; impurity; bribery.”

Corruption is when a fraudster uses his influence in a business transaction to procure some benefit for himself or another person contrary to his duty to his employer (in our case, the citizen or taxpayer) or the rights of another.

For those of you who already work in the government environment, you will appreciate the references that follow.  For the rest of you, put on your red or blue taxpayer hat, this is going to get political!

When a public servant is corrupt, she forgets her duty to serve the public, as the GAO’s Yellow Book calls us to do, and instead serves herself.

2.07     A distinguishing mark of an auditor is acceptance of responsibility to serve the public interest.

Have you seen the corruption index?  A group called Transparency International ranks the corruption of the world’s countries on its website: http://www.transparency.org/policy_research/surveys_indices/cpi/2010/results.  America is ranked #22. Denmark is ranked number one as the least corrupt country?

The Association of Certified Fraud Examiners has divided the corruption section of the fraud tree into four parts:

  1. Conflicts of interest
  2. Bribery
  3. Illegal gratuities
  4. Extortion

3-9-1 Conflicts of Interest

Conflicts of interest arise when a fiduciary, agent, or employee does not act in good faith, with full disclosure, in the best interest of the principal but instead is serving other interests.

Conflicts of interest occur when persons in power have interests outside of their job and sway their decisions to benefit these interests.

In auditing, a conflict of interest threatens your independence and objectivity. The Yellow Book reminds you to stay clean and avoid corruption:

3.07     Auditors participating on an audit assignment must be free from personal impairments to independence. Personal impairments of auditors result from relationships or beliefs that might cause auditors to limit the extent of the inquiry, limit disclosure, or weaken or slant audit findings in any way.

In a small town, conflict of interest is a constant threat.  If you know everyone in town, how do you keep your objectivity?

The mayor of the City of Brandon says he was not in a conflict of interest when he voted along with City Council to allow a local developer to purchase $812,000 in land from the city.  This local developer was one of the mayor’s campaign volunteers.

“I don’t gain personally from anything to do with the applicant or any of the other applicants as well,” he told the Sun. “Of the five applicants (for the land), I know every single one of them.”

The Municipal Council Conflict of Interest Act states that a conflict of interest exists where a person stands to either directly or indirectly financially benefit from a decision of council.1

3-9-1A Purchases Schemes

Purchasing professionals have a lot of power that may go unchecked.  When I work for a government entity, they usually make me jump through hoop after hoop after hoop to prove that they were objective in their choice, although usually we both know that I am their first choice.

I frequently get requests for bids from governments with which I have no relationship.  But, I know they are usually just going through the motions.  I am not going to waste my time bidding on a job that I know someone else has locked in. And, unfortunately, a lot of people’s time is wasted in the process, especially when the bidding documents are 20 pages long!  But looks can be everything when it comes to purchasing. Is this the ideal?  No. True? Yes.

State criminal investigators are looking at efforts by the Oregon Department of Energy to steer federal money to a company run by the Governor of Oregon’s girlfriend after her firm lost the bid on a state contract. The winner of the bid was encouraged by the Department of Energy to include the girlfriend in the contract. The girlfriend was eventually employed as a subcontractor.  Three Energy Department officials happened to be on leave during the investigation.2

3-9-1B Sales Schemes

If you watch Fox News, you are familiar with Goldline Commercials.  In mid-2010, Congress formally opened an investigation of Goldline following an exposé on ABC News which detailed Goldline’s business model.3

Goldline employs several conservative pundits including Glenn Beck, Mike Huckabee, Laura Ingraham, and Fred Thompson to sell gold coins on the air. By feeding public fears during the recession, conservative pundits encourage their listeners to invest in gold.

Glenn Beck, for example, has dedicated entire segments of his program to explaining why the U.S. money supply is destined for hyperinflation with Barack Obama as president. He often promotes the purchase of gold as the only safe investment alternative for consumers who want to safeguard their livelihoods. When the show cuts to commercial break, viewers are treated to an advertisement from Goldline.

Goldline marks up its coins an average of 90% over the melt value of the coin.  The largest markup on any coin was 208% above the melt value. By selling gold at twice the melt value, the price of gold would need to double for consumers to break even on their “investment.” However, since Goldline is not licensed as an investment advisor, they have no responsibility to advise their clients.

Paul Harvey, the radio newsman whom my grandmother listened to on country radio, used to use a similar sales scheme. He’d talk about a snowstorm in Montana and, before you know it, you were being pitched some sort of miracle skin lotion. He was smooth. But I remember all of his ads as being relatively benign and for products that cost under $100.  I could be wrong.

3-9-1C Other Schemes

Wouldn’t it be great to create the rules you later have to follow?  Should consultants on government contracts draft the rules regarding those contracts?

Science Applications International Corporation served as an advisor to the Nuclear Regulator Commission to develop rules for recycling radioactive materials released from nuclear facilities.  At the same time, they entered into a partnership with another corporation, British Nuclear Fuels, to perform the recycling.

In a 2008 decision, a federal jury concluded that the firm’s executives knowingly concealed business interests that stood to benefit from its consulting role at the NRC. It found that SAIC had made 17 false statements and 60 false claims under the Federal False Claims Act.4

That story reminds me of a friend of mine who ran an internal audit shop at a state agency.  She hired an experienced CPA from inside the agency as a senior auditor.  Not until after she hired her and tried to assign her to projects did she realize her mistake.

The CPA had worked for the agency for five years in a variety of capacities. She was also married to one of the division directors and socialized with most of the others.  She was useless as an auditor because she was not independent of the audit subjects. Interestingly enough, my friend became a director of one of the divisions, and the administration decided to promote the less-than-objective CPA to director of audit.  Hmm.

3-9-2 Bribery

Bribery is when a person pays an official to make a decision in his favor.  The person in need offers or gives something of value to influence the action of an official in the discharge of his public duties.

Contractors for the federal government frequently appear in the news for bribing federal officials in hopes of landing lucrative contracts.

What follows is a portion of a press release from the
Department of Justice regarding one of our honorable congressmen:

Former Congressman William J. Jefferson Convicted of Bribery, Racketeering, Money Laundering, and Other Related Charges5In August, 2009, after a month of testimony in a federal court, a jury found former Congressman William J. Jefferson guilty on 11 charged counts, including solicitation of bribes, honest services wire fraud, money laundering, racketeering, and conspiracy.“We have been reminded today that we are a nation of laws, and not men,” said Dana J. Boente, U.S. Attorney for the Eastern District of Virginia. “It should be a clear signal that no public official – and certainly not a U.S. Congressman – can put their office up for sale and betray that office. It cannot be tolerated. It cannot just be another cost of doing business. And today, a jury of his peers held Congressman Jefferson accountable for his actions.”

“Trust and integrity in public officials is at the heart of our democracy,” said Joseph Persichini Jr., Assistant Director of the Washington Field Office of the FBI. “What a better way to ensure those virtues, than to expose those who breach that trust.”

According to evidence at trial, from August 2000 to August 2005 Jefferson used his position as an elected member of the U.S. House of Representatives to corruptly seek, solicit and direct that things of value be paid to himself and his family members in exchange for his performance of official acts to advance the interests of people and businesses who offered him the bribes. The things of value, according to evidence at trial, included hundreds of thousands of dollars worth of bribes in the form of payments from monthly fees or retainers, consulting fees, percentage shares of revenues and profits, flat fees for items sold, and stock ownership in the companies seeking his official assistance.

Evidence at trial showed that Jefferson performed a wide range of official acts in return for things of value, including leading official business delegations to Africa, corresponding with U.S. and foreign government officials, and utilizing congressional staff members to promote businesses and businesspersons. The business ventures that Jefferson sought to promote included telecommunications deals in Nigeria, Ghana, and elsewhere; oil concessions in Equatorial Guinea; satellite transmission contracts in Botswana, Equatorial Guinea and the Republic of Congo; and development of different plants and facilities in Nigeria.

Siemens pays huge fine
In 2008, the German engineering conglomerate Siemens paid an $800 million dollar fine to the Securities and Exchange Commission and the Department of Justice for widespread bribery of government officials. Among the billions authorities accuse Siemens of paying out to government officials is a $2.6 million payout to former Argentinean president Carlos Menem in order to win a bid to manufacture national ID cards for the country. Other allegations include a $55 million bribe to Russian officials for a medical devices contract, and $22 million to China for a metro trains contract.6

Chinese Officials Love Gucci!
Our fascination with China continues. They have really good taste, after all.

China seems to be the fastest growing country in every category, and now we can add fastest growing luxury market to the list.  Gifts to government officials are prohibited in China, but who can resist a Swiss watch?  Especially a $30,000 diamond studded one? It is just one little watch!

Bain & Company, a global consulting firm, estimated luxury sales of $7.6 million in 2008.  Industry experts say gifts to government officials make up close to 50% of that figure.  During the Communist Party meetings in March of 2009, sales of luxury goods in Beijing spiked.

One snobby land confiscation official in Chongqing was sentenced to 13 years in prison for accepting kickbacks.
Chinese officials confiscated 200 pairs of luxury shoes, 100 luxury suits, and a luxury car.  He even had the nerve to tell his female trial lawyer that she needed to polish her low quality shoes. I wonder what sort of shoes they will issue him in prison. Gucci?

China is countering this corruption with talk of creating a national registry to track the assets of government officials. 7

3-9-2A Invoice Kickbacks

Invoice kickbacks cause a client to be overcharged while the vendor and their fraudster friends share in the proceeds!

You wouldn’t steal food from a kid, would you?
What about stealing money that was intended to pay for kids’ lunches? Sodexo, the world’s largest food purchaser, had received rebates from food suppliers that it failed to pass on to the districts.

In order to continue to do business with the state, Sodexo paid a $15M fine to the state of New York for overcharging New York School district cafeterias. The organization also agreed to disclose rebates in writing to clients, establish a hotline for clients and whistleblowers, and pay for an independent audit of their compliance with rebate provisions of their contracts.8

3-9-2B Bid Rigging

Will I ever feel good about banks and Wall Street again?  I don’t think so.  I am afraid our business schools are churning out opportunistic financiers looking for a quick buck!  And unsophisticated governments are easy targets with lots of money.

Local governments beware of big banks offering investments!
Local governments often hire brokers to help them find investment contracts so that the government earns interest on millions of bond proceeds set aside for long-term projects. The U.S. Treasury requires that these contracts be bid on competitively to maintain the tax-exempt status of the proceeds.

Bank of America, however, decided in advance which bank would be the winner of certain contracts. They did their best to cover their tracks.  They occasionally submitted intentionally losing bids so that the bidding would look legitimate. As a result of bid manipulation, the Justice Department said Bank of America won investment contracts at “artificially determined price levels, which deprived municipal issuers of money and property.”  And, as of this writing, the investigation has only just begun.  On June 22, 2012, Moody’s downgraded Bank of America’s public finance obligations.

“This ongoing investigation has helped to expose widespread corruption in the municipal reinvestment industry,” said Robert Khuzami, director of enforcement at the SEC, one of the agencies in the probe. “The conduct was egregious – in return for business, the company repeatedly paid undisclosed gratuitous payments and kickbacks and affirmatively misrepresented that the bidding process was proper.”

As a result, four federal agencies and 20 states received a sweeping $137 million in their settlement with Bank of America for its role in a bid-rigging scheme that ripped off state agencies, cities, towns, and not-for-profits seeking to invest yet unspent bond proceeds.9

Here is a press release from the Department of Justice in a related case.

Former Agent Of Financial Products And Services Company Pleads Guilty For Role In Fraud Conspiracies Involving Proceeds OfMunicipal Bonds10A former agent of a financial products and services company pleaded guilty today for his participation in fraud conspiracies related to contracts for the investment of municipal bond proceeds and other municipal finance contracts, the Department of Justice announced.According to plea proceedings today in U.S. District Court in New York City, Adrian Scott-Jones, a resident of Morriston, Fla., pleaded guilty to participating in two separate fraud conspiracies with companies that provide a type of contract, known as an investment agreement, to public entities throughout the United States, such as state, county and local governments and agencies. These public entities were seeking to invest money from a variety of sources, primarily the proceeds of municipal bonds that they issued to raise money for, among other things, public projects. Scott-Jones also pleaded guilty to one count of wire fraud. According to the plea agreement, Scott-Jones has agreed to cooperate with the ongoing investigation.

The department said in court documents that Scott-Jones’ former company, located in North Palm Beach and Ocala, Fla., marketed financial products and services, including services as a broker or advisor to various public entities that issue municipal bonds. Public entities typically hire a broker to conduct a competitive bidding process for the award of investment agreements. Major financial institutions, including banks, investment banks, insurance companies and financial services companies, are among the providers of investment agreements and other related municipal finance contracts. Competitive bidding for these agreements is the subject of regulations issued by the U.S. Department of the Treasury and is related to the tax-exempt status of the bonds.

According to court documents, Scott-Jones participated in one fraud conspiracy from as early as September 2001 until at least November 2006, and in a second fraud conspiracy from as early as August 1999 until at least November 2006. In each conspiracy, Scott-Jones gave co-conspirator providers information about the prices, price levels or conditions in competitors’ bids, a practice known as a “last look,” which is explicitly prohibited by U.S. Treasury regulations. Scott-Jones also solicited and received intentionally losing bids for certain investment agreements and other municipal finance contracts. As a result of the bid manipulation, the co-conspirator providers won contracts at artificially determined price levels, which deprived municipal issuers of money and property.

The court documents also charge that Scott-Jones and co-conspirators misrepresented to municipal issuers or their bond counsel that the bidding process was in compliance with U.S. Treasury regulations. This caused the municipal issuers to award investment agreements and other municipal finance contracts to providers that otherwise would not have been awarded the contracts if the issuers had true and accurate information regarding the bidding process. Such conduct caused municipal issuers to file inaccurate reports with the Internal Revenue Service (IRS) and thus placed the tax-exempt status of the underlying bonds in jeopardy.

Each of the fraud conspiracies for which Scott-Jones is charged carries a maximum penalty of five years in prison and a $250,000 fine. The wire fraud charge carries a maximum penalty of 20 years in prison and a $250,000 fine. The maximum fines for each of these offenses may be increased to twice the gain derived from the crime or twice the loss suffered by the victims of the crime, if either of those amounts is greater than the statutory maximum fine.

This is the sixth guilty plea to arise from an ongoing investigation into the municipal bonds industry, which is being conducted by the Antitrust Division’s New York Field Office, the FBI and IRS Criminal Investigation. The department is coordinating its investigation with the Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Federal Reserve Bank of New York.

Three former employees of Rubin/Chambers, Dunhill Insurance Services Inc., also known as CDR Financial Products, a Beverly Hills, Calif.-based financial products and services firm that acted as a broker of investment agreements and other municipal finance agreements, have pleaded guilty to bid-rigging and fraud conspiracies in relation to the ongoing investigation. Two other individuals have also pleaded guilty to charges related to the ongoing investigation.

As a result of the ongoing investigation, three former financial services executives were indicted on July 27, 2010, for participating in fraud schemes and conspiracies related to the bidding for investment agreements. In addition, CDR, two of its employees and one former employee were charged in October 2009 for participating in bid-rigging and fraud conspiracies and related crimes. The CDR trial is scheduled to begin on Sept. 12, 2011.

3-9-3 Illegal Gratuities

When someone gives a public official a gift that isn’t necessarily tied to any particular favor, it is probably intended to influence the official’s future decisions.

Imagine a government official who encourages corporations to fund his campaign.  The corporations and the official understand that the corporations will experience preferential treatment.  Sound like some remote South American banana republic?  Unfortunately, this is how our ‘system’ works in America.

If a lobbyist gives a government official a significant campaign contribution and helps her raise more money for her campaign while at the same time explaining his position on, let’s say, health insurance, is that bribery, extortion, or illegal gratuities?  Or is the congresswoman suffering from conflict of interest?  The behavior of our U.S. Congresswoman might be considered all three at once.

I got in hot water a few years ago with one of my government clients. One of my last names is Hart, and so I thought it would be cute to send out Valentine’s gifts to my clients instead of Christmas presents. Get it? Hart, Valentines?  So, I sent a small heart-shaped dish full of dove chocolate to one of my legislative audit clients.  And they promptly sent it back to me with a scolding letter from their lawyer admonishing me never to give them a gift again.  I guess they thought an $8 gift would make them hire me for the next decade.  I wish it were that easy to get business!

3-9-4 Extortion

Some people mistakenly call bribery “extortion” and extortion “bribery.” The difference between bribery and extortion is in who makes the first move.  The person wanting a favor from a powerful person initiates bribery.  And the person in power initiates extortion: in extortion the public official asks for goodies instead of being offered goodies.

One contractor conveyed that the head of the purchasing department for a large city always held a meeting with the bidders on a project before the project was awarded.  The experienced contractors realized that he was asking for gifts when he said things like, “My car is so filthy.  It needs a detailing!” “Or, my lawnmower sure is getting tired.” Whichever contractor took care of his car or his lawnmower got the job.

David Letterman was in the news in 2009 because the boyfriend of the woman with whom he was having an affair threatened to expose his infidelities to the public unless David Letterman paid the boyfriend several million dollars.  David Letterman decided to fess up on the air, but he turned the boyfriend into the authorities first.  What an interesting turn of events for the boyfriend.  He is broke, girlfriendless, and in prison for extortion.

If you have the power, you can demand the money!
Broward County Public School Board member Beverly Gallager, was arrested for extortion, wire fraud, and bribery after undercover FBI agents passed $12,500 to her in return for her awarding construction contracts.  U.S. Representative, Debbie Wasserman Shultz, was appalled saying, “It shakes the confidence of the public in their elected leaders.”11


1 Allison Dowd. “Mayor says decision didn’t put him into conflict of interest.” The Brandon Sun. September 29, 2010.
2 Brent Walth and Michelle Cole. “Department of Energy officials promoted firm run by ex-Gov. John Kitzhaber’s girlfriend for project.” The Oregonian [Portland]. August 23, 2010.
3 Matthew Mosk. “Exclusive: Glenn Beck’s Golden Advertiser Under Investigation.” ABC Nightline. ABC. July 19, 2010. Television.
4 Robert O’Harrow Jr. “Potential for Conflict Grows With Government’s Use of Contractors.” Washington Post. August 18, 2008.
5 United States. Department of Justice. Former Congressman William J. Jefferson Convicted of Bribery, Racketeering, Money Laundering, and Other Related Charges. FBI. August 5, 2009.
6 “Siemens Pays out $800M in Fraud Settlement.” National Association of Corporate Directors Directorship. Web. December 15, 2008.
7 David Barboza. “For Bribing Officials, Chinese Give the Best.” The New York Times. March 13, 2009.
8 Lucy Komisar. “Sodexo, exposed by Komisar for kickbacks, agrees to $20m settlement.” The Komisar Scoop. Web. July 21, 2010.
9 Rick Rothacker. ”Bank of America reaches bid-rigging settlement.” Charlotte Observer.  December 7, 2010.
10 United States. Department of Justice. Former Agent of Financial Products And Services Company Pleads Guilty For Role In Fraud Conspiracies Involving Proceeds Of Municipal Bonds. Press release. Washington, D.C. September 8, 2010.
11 “Broward County School Board member arrested.” Sunshine Review Gazette. September 24, 2009.

Fraud Risk per the GAO’s Green Book

Just because you’re unaware of the risk, doesn’t mean it isn’t there

Just because you aren’t conscious of something dangerous, doesn’t mean it isn’t lurking.   One of the most important themes of the GAO’s Green Book (and the 2013 COSO model it is sourced from) is consciousness.  Instead of just playing along with the crowd without regard to the risk, the Green Book encourages you to become conscious of risk, imagine the worst, and then plan to prevent it.

Do you think that people in the 1940’s had a sneaking suspicion that smoking was unhealthy?  Or do you think their desire to be glamorous like all those smoldering (forgive the pun) Hollywood movie stars overrode their common sense?

And in the 70’s my mom and dad slathered themselves with olive oil and lay in the sun to get a reddish brown ‘tan’.  Coppertone products promised to magnify the power of the sun.  Now my dad gets skin cancer removed from his face, arms, and hands every six months or so.

Everybody went nuts buying non-stick cookware in the 80’s only to find out that the Teflon emits dangerous gasses into your food when heated.  In the 90’s we all started drinking bottled water with no concern for the environmental impact, and in the 2000’s we went ‘wireless’ and may be exposing our brains to harmful radio waves.  Lately, we all have to concede that if we transact with the world at all, our personal data is out there and available to criminals in Russia.

I am thinking of that classic parental line here, “If your crazy friend Carl jumped off a bridge, would you do it to?”  Going along with the crowd can be dangerous.

Sometimes you can pre-empt negative consequences

It is all very nice to look back in hindsight and realize that you shouldn’t have followed the crowd and jumped off that bridge.  But sometimes, you can work ahead of a problem to prevent bad results.

For instance, I opened a new business account at a bank recently.  And I know that it is dangerous to give my bank account number to folks who are making deposits into my account and/or who have the power to withdraw money from my account.  But I put the risk out of my mind because I didn’t think I could do anything about it.

Hand me the Coppertone, I’ll play along!  My thinking was, “That’s how business is done and I want to play.”

But my new bank has thought about this risk and offered me not one, but two checking accounts.  I can share one checking account number with vendors and customers who are coming in and out of my account and the other account – where the bulk of my money is – is accessible and known only to me and my bookkeeper.  Nice.

Fraud is real but it isn’t entirely unavoidable

The Certified Fraud Examiners estimate that 5% of an organization’s annual revenue is lost to fraud.   http://www.acfe.com/rttn2016/docs/Staggering-Cost-of-Fraud-infographic.pdf

And although the Certified Fraud Examiners don’t say it outright, they are implying that most organizations suffer fraud.   If an organization grows to over 100 employees, someone is probably doing something squirrely.

I spent a year writing a self-study book on Fraud for Government Auditors.  Unfortunately, I wrote it in 2008 as our economy was crashing.   As I wrote, I became hyper-aware of bad behavior and fraud everywhere I went.  It was exhausting and disheartening to see fraud every time I left the house or read the news, so 8 years later, I have turned the consciousness dial down quite a bit and become mostly numb to it once more. There is only so much moral outrage you can muster day after day after day.

The Green Book asks the leaders of the organization to think about fraud before it happens.  It is asking them, for at least a few days while they prepare a risk assessment, to muster some moral outrage before the organization actually suffers fraud so that they can plan around it, just like my new bank.

Fraud risk specifically

So in our last chapter, we discussed inherent risk in general and how the Green Book encourages us to think about the risk of death, injury, shame, loss of money or non-achievement of goals.

Now, we are going to focus on fraud risk specifically.  Fraud can cause injury, shame, loss of money, or non-achievement of goals.  But occupational fraud, the fraud discussed in the Green Book, is not likely to cause death.

The GAO dedicates a good portion of the chapter in the Green Book on risk assessment to assessing fraud risk.

Principle 8 states: 8.01: Management should consider the potential for fraud when identifying, analyzing, and responding to risks. 

Luckily, the GAO’s green book doesn’t stop there, but instead, shares several models that will help us be more conscious of fraud as we are assessing fraud risk: the fraud tree and the fraud triangle. We are going to discuss each in turn.

Like a good spiritual guide, the fraud tree and fraud triangle enhance consciousness

Both the fraud tree and the fraud triangle have helped me see fraud where I didn’t see it before.  And once your consciousness has been raised, you see new things everywhere.

You may have experienced this with your car.  I am the happy owner of a plain white Lexus sedan.  Before I owned a Lexus, I was oblivious to how many were on the road. Now I see them everywhere.  You remember that weird movie called The Sixth Sense… where the lead declares “I see dead people!”?  I see Lexi.

A broad overview of the fraud tree

As a supplement to this article, I am also going to publish a series of chapters from my book on fraud so you can get to know the fraud tree in more detail.  Be looking for those over the next few weeks. But in this short article, we are just going to do a broad overview of the fraud tree.

So don’t read any of those newsletters or read the rest of this newsletter unless you want to see fraud everywhere.

THE FRAUD TREE

A fraud investigator once told me, fraud is lyin’, cheat’n, and steal’n.  But the Certified Fraud examiners are more formal about classifying fraud and use much better grammar.  The Certified Fraud Examiners came up with a whole taxonomy of occupational fraud which they dubbed the ‘fraud tree.’  If you are having a hard time reading the graphic below, visit the Certified Fraud Examiners page at http://www.acfe.com/fraud-tree.aspx for a clearer graphic.

Fraud Tree

The fraud tree divides fraud into three categories:

Corruption

Misappropriation of assets

Fraudulent reporting

Corruption includes bribery and extortion – which are flip sides of the same coin.  When a person without power pays a person in power for a favor, it is a bribe. When a person in power demands payment from someone who needs a favor, it is extortion.

A contractor with a Texas county told me that he and all of the other contractors knew that in order to win contracts, they would have to give expensive gifts to the county purchaser. Whenever requests for proposals were discussed with contractors, the purchaser would mention things he needed for his house – like a new grill or a lawnmower.  The contractors knew that whoever was first to buy the grill or lawnmower would win the contract. Eventually, the purchaser’s requests became more extravagant and frequent. The contractors had to take turns bidding on contracts, so they could distribute the extra expense more evenly among them.

Corruption also includes illegal gratuities.  An illegal gratuity is when you reward or pay someone in advance in hope of future favor. This is the way the US Congress works. Corporations and lobbyists support campaigns and slather favors on Congressmen in hopes that the Congressman’s decisions on future legislation will be favorable to them.

The last category in corruption is conflict of interest.  This is a wide category of bad behaviors where favors are granted to friends and family.  My friend has recently been elected treasurer of her homeowner’s association.  She has already found out that the chairman of the board is awarding work to companies that his daughters own.  My friend suspects, but cannot prove yet, that the chairman owns the companies and that the daughters are owners on paper only.

The second branch of the tree is misappropriation of assets. Misappropriation of assets is when cash or other assets of the organization are stolen or misused.  Notice that the fraud tree has two main branches under misappropriation of assets – 1. cash and 2. inventory and other assets.

fraud2

Cash can be stolen in three ways; cash can be taken after it has been captured in the accounting records (larceny), or before it hits the accounting records (skimming), or it can be disbursed in what looks like legitimate transactions for illegitimate purposes, like payments to fake (ghost) emplo

yees or fake (shell) companies.  As you can tell from the tree, cash misappropriation includes a wide variety of creative categories for fraudsters to choose from.

Other assets, like inventory and fixed assets can be stolen or misused.  The mail clerk in a state agency I worked for was using the state’s van on weekends to deliver pizzas!

And the last category is fraudulent statements.  We are all aware of the infamous financial statement fraud scandals at Enron and WorldCom that wreaked havoc on our national economy.  But we might not be as well acquainted with non-financial statement fraud.  A false claim or statement for personal gain falls into this category.  Fifty-eight percent of hiring managers said they’ve caught a lie on a resume per a Career Builder Survey concluded in 2014. http://www.careerbuilder.com/share/aboutus/pressreleasesdetail.aspx?sd=8%2F7%2F2014&id=pr837&ed=12%2F31%2F2014  And many governments use performance measures to convince grantors and the citizenry that they are doing a good job handling public resources. But as you can imagine, sometimes these performance measures are altered, manipulated, or even completely made up.

One of my favorite stories about fraudulent performance measures is about the Public Works Department in the City of San Deigo. Their Public Works Department said they filled potholes within a week, when the truth is most potholes took months to repair.  When asked about the discrepancy, the Public Works Department said that their definition of repaired does not meet most people’s definition of repaired.  Tricky?  Yes.  Fraudulent?  I’d say so because the managers in the Public Works Department benefited from exaggerating the Department’s effectiveness.  See the amusing article about this fraud here: http://www.voiceofsandiego.org/topics/government/the-citys-false-pothole-pledge/

When I audited performance measures at a state department of criminal justice (the state prison system), I found that most measures were pulled directly out of the sky.  They were estimates that made the department look good, not measures of real results.

If you were reading closely, you might have noticed a small difference in wording

I don’t really know why the GAO and the COSO model chose to leave out non-financial statement fraud from their literature, but they did.  Here is the quote referring to the fraud tree in the Green Book:

Green Book 8.02 Management considers the types of fraud that can occur within the entity to provide a basis for identifying fraud risks.  Types of fraud are as follows:

  • Fraudulent financial reporting - Intentional misstatements or omissions of amounts or disclosures in financial statements to deceive financial statement users. This could include intentional alteration of accounting records, misrepresentation of transactions, or intentional misapplication of accounting principles.
  • Misappropriation of assets - Theft of an entity’s assets. This could include theft of property, embezzlement of receipts, or fraudulent payments.
  • Corruption - Bribery and other illegal acts.

See how the Green Book doesn’t talk about fraudulent statements in general but fraudulent financial statements only.

If you are an aficionado of SAS 99 (now AU 316), the AICPA’s guidance on an auditor’s responsibility for detecting fraud, you may recognize that the AICPA focuses their discussion of fraud on fraudulent financial statement reporting only.  This makes sense because the AICPA is clear about its audit objective – to opine on whether the financial statements are created in accordance with an accounting standard (usually GAAP).  But the Green Book – because it covers an entire organization, should include all components of the fraud tree.

If you know the reason for this, please share.  Otherwise, I am going to say it is a flaw of the Green Book until someone can convince me otherwise.

Next time, we will discuss the fraud triangle and do an example fraud risk assessment.

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