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The CACM Review: Sample Content, Questions & Answers
Part 3: Fraud and Corruption
The following is a partial excerpt of part 2 accompanied by its review questions and answers.
Before delving into the definitions of fraud and corruption, we introduce the following crucial relevant terms:
Black's Law Dictionary defines fiduciary as
(as a noun) a person holding the character of a trustee, or a character analogous to that of a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor which it requires. Thus, a person is a fiduciary who is invested with rights and powers to be exercised for the benefit of another person. (As an adjective) it means of the nature of a trust; having the characteristics of a trust; analogous to a trust; relating to or founded upon a trust or confidence.
West’s Business Law defines fiduciary as
As a noun, a person having a duty created by his or her undertaking to act primarily for another’s benefit in matters connected with the undertaking. As an adjective, a relationship founded on trust and confidence.
and it defines fiduciary duty as
The duty, imposed on a fiduciary by virtue of his or her position, to act primarily for another’s benefit.
Duty of Care and Duty of Loyalty
Black's Law Dictionary defines duty of care as
A legal requirement in certain systems where the board of directors and executives must make informed decisions in discharging their fiduciary responsibilities.
An informed decision is generally based on gathering all relevant facts and material, giving such information due consideration, and then making a decision. A breach of duty of care can lead to legal action by shareholders.
and it defines duty of loyalty as
A legal requirement in certain systems where the board of directors and executives must ensure that any action taken is done in good faith and with the best interests of shareholders in mind. A breach of duty of loyalty can lead to legal action by shareholder.
Fraud, as defined by West’s Business law, is any misrepresentation, either by misstatement or omission of a material fact, knowingly made with he intent of deceiving another and on which a reasonable person would and does rely to his or her detriment.
The common law defines fraud as follows:
THEN, this act is fraudulent.
The Association of Certified Fraud Examiners (ACFE) stated the following in its Report to the Nations on Occupational Fraud and Abuse, 2012 Global Fraud Study:
The term fraud has come to encompass many forms of misconduct. Although the legal definition of fraud is very specific, for most people — anti-fraud professionals, regulators, the media and the general public alike — the common usage is much broader and generally covers any attempt to deceive another party to gain a benefit. Health care fraud, identity theft, padded expense reports, mortgage fraud, theft of inventory by employees, manipulated financial statements, insider trading, Ponzi schemes — the range of possible fraud schemes is large, but at their core, all of these acts involve a violation of trust. It is this violation, perhaps even more than the resulting financial loss, that makes such crimes so harmful.
The ACFE defines occupational fraud as:
The use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets
This ACFE definition of fraud focuses on occupational fraud schemes in which an employee abuses the trust placed in him or her by an employer for personal gain. An employer in this context could be any employer whatever the sector is: public or private sectors, charities, non-profit organizations, etc.
The AACI defines corruption as “Abuse of power or perceived power or entrusted authority for direct or indirect private monetary or non monetary gain.”
This definition applies to all economic sectors and entities. It applies to private and public sectors and also applies to non-profit entities.
The existence of power precedes corruption occurrence. Therefore if you do not have power, you will not (generally) lead or initiate a corrupt act.
Perceived power means a power that others presume associated with those who are seemingly acting on behalf of those who actually having power.
“Prominent international organizations adopt a similarly inclusive definition of corruption. The United Nations Office on Drugs and Crime emphasizes that corruption “can occur in both the public and private domains.” Its Global Program Against Corruption (GPAC) defines corruption as the “abuse of power for private gain” and includes thereby both the public and private sector. Similarly, the World Bank does not regard corruption as confined to the public sector and has identified several cases of corruption among private corporations. For Transparency International, corruption is operationally defined as “the misuse of entrusted power for private gain.” This too covers individuals in both the private and public sectors.”
At a national level, domestic laws are the only source and authority that determine what is and what is not a fraud. They are the only source to determine what acts are corrupt and what acts that are not corrupt. In other words, fraud and corruption definitions are solely detrained based on the domestic laws. However, there is almost an international consensus on what corruption is since 2005 when the United Nations issued the United Nations Convention Against Corruption (UNCAC).
“The OECD, the Council of Europe and the UN Convention do not define “corruption”. Instead, they establish the offenses for a range of corrupt behavior. Hence, the OECD Convention establishes the offense of bribery of foreign public officials, while the Council of Europe Convention establishes offenses such as trading in influence, and bribing domestic and foreign public officials. In addition to these types of conduct, the mandatory provisions of the UN Convention also include embezzlement, misappropriation or other diversions of property by a public official and obstruction of justice. The conventions, therefore, define international standards on the criminalization of corruption by prescribing specific offenses, rather than through a generic definition or offense of corruption.”
The OECD elaborates further and states that international definitions of corruption for policy purposes are much more common. One frequently-used definition that covers a broad range of corrupt activities is the “abuse of public or private office for personal gain”. This definition can be a useful reference for policy development and awareness-raising, as well as for elaborating anti-corruption strategies, action plans and corruption prevention measures.
As domestic laws are the ultimate authority on what fraud and corruption are, one should not be surprised when some acts are considered illegal in one country while they are not in another one. Though it did not define it, the UNCAC created a consensus among the countries that ratified it on what corruption is.
Any fraudulent or corrupt act breaches each one of the following duties:
Though we will be using the words of fraud and corruption interchangeably, we will be specific when we address fraud and corruption classifications in accordance with those of the Association of Certified Fraud Examiners and when we discuss financial statements fraud.
Misconceptions About Fraud and Corruption
The following is not an exhaustive list of misconceptions about fraud and corruption that is widely spread all over the world. The lower the illiteracy, the lower the level of these misconceptions. The higher the anti-corruption literacy, the lower the level of these misconceptions.
Costs and Damages of Fraud and Corruption
Corruption results in severe socio-economic damages. The Secretary-General's message on 2016 International Anti-Corruption Day described the extent of those damages succinctly.
“No country is immune, and every country bears a responsibility to end it. [corruption]
Corruption strangles people, communities, and nations. It weakens education and health, undermines electoral processes and reinforces injustices by perverting criminal justice systems and the rule of law. By diverting domestic and foreign funds, corruption wrecks economic and social development and increases poverty. It harms everyone, but the poor and vulnerable suffer most.
The theme of this year’s observance is “Corruption: An impediment to the Sustainable Development Goals”. Goal 16 urges substantial reductions in corruption and bribery and the development of effective, accountable and transparent institutions at all levels. The UN Convention against Corruption, buttressed by its peer review mechanism, is mobilizing action for honest, transparent, accountable governance, but far more is needed.”
As stated by the U.N. Secretary-General, corruption:
Because clandestine is the nature of fraud and corruption, its real cost is an estimate. On the average, an entity loses annually 5% of its sales (revenues) due to fraud and corruption. As the world 2016 Gross Domestic Product (GDP) amounted to USD 75.6 trillion, the world economy lost at the minimum USD 3.9 trillion due to fraud and corruption.
Corruption Costs - Entity Level
Fraud and corruption damages affect each of the following at the entity level irrespective of its size, nature of the business, or location. The extent of damage differs among organizations due to several factors. However, the cumulative damage of fraud and corruption at the entity level is devastating and sometimes irreparable.
1. Internal Costs
Fraud and corruption hidden costs must ultimately be reflected in a lower net income or profit. Depending on what cost component(s) absorbed such costs, gross profit and / or net income will be understated. This results in distorted financial statements and inaccurate financial ratios.
For example: assume the annual reported net sales and cost of goods sold of ABC company were USD 1,000,000 and USD 800,000 respectively. Gross profit is USD 200,000, and the gross profit ratio is 20% (Gross profit ratio = Gross Profit / Net Sales). However, the management of ABC company did not know that there was a bribe amounting to USD 100,000 paid to a public official to award a bid to the company. The bribe was recognized in the cost of goods sold. The bribe overrated cost of goods sold by USD 100,000, understated gross profit by USD 100,000 and understated gross profit ratio by 10% ( 30% without bribe inclusion in the cost of goods sold minus 20% -with bribe inclusion in the cost of goods sold)
Fraud and corruption are inversely related with each of these employees’ significant characteristics.
For example: when management encourages employees to get business irrespective of ethical and/or legal implications, employees would understand that their performance evaluation would be based on their unethical or even illegal business conduct. This would frustrate the competent and ethical employees morale who refuse to follow management implicit or, unfortunately, explicit instructions. Such internal business culture will negatively affect employees' morale, productivity, loyalty, and innovation.
Following on the above example, the entity's competitiveness will suffer as a result of poor productivity, lack of innovation, and high employee turnover.
(d) Strategic goals and objectives
As corruption risks increase, the organization undermines its ability to pursue its mission. Organizations should take into consideration fraud and corruption risks in formulating, implementing, and evaluating its strategies.
Corruption was not and will never be cost-free. The most important resource an organization loses is its talented employees. Waste associated with fraud and corruption could be financial and non-financial. For example, a business image would be affected when an organization makes news headlines in corruption or fraud case.
2. External Costs
Whenever fraud and corruption hit an organization, its damages immediately become visible. For example, the Dieselgate of Volkswagen affected its stock price significantly within less than twenty-four hours once the scandal became known to the public. Volkswagen's legal and regulatory costs are still mounting.
An organization that shows commitment to honesty, integrity, transparency and implements corruption prevention policy would enjoy a lower cost of capital compared to those entities of high corruption risks.
Corruption Costs - State Level
Corruption significantly and negatively affects sustainable development at the national level. It destroys the fundamental political, social and economic foundations of any country at any time and place. It threatens the stability and security of the nation state in the comprehensive sense of security. For example, when bribery and corruption spread in a society, citizens' trust in public institutions is shaken. More significantly, the national identity decays over time. It is not an exaggeration when we say that corruption threatens countries’ prosperity and existence. No wonder that corruption is one of the characteristics of failed nations.
The list of items stated above is not exhaustive. In fact, each aspect of a country’s institutional functions is exposed to corruption. Academic institutions and the healthcare sector are of utmost importance to immune them against fraud and corruption. Numerous types of fraud and corruption could hit educational institutions (i.e., universities, schools, etc.) and healthcare.
For example, when admission to particular school colleges is not based on merits, the output of such colleges would be inferior and of low quality. When one should pay a bribe to expedite an appointment for carrying out a medical operation, the healthcare system as a whole is in jeopardy.
We believe that the rule of law is a prerequisite for any well-intentioned and well-structured corruption prevention policies. When the public perceives that the law is applied selectively, corruption thrives, talented citizens leave the country, foreign direct investment plummets, tax evasion increases, equality at all levels diminishes, and a path towards a failed state status takes shape over time.
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