Corporate Frauds:

Prevention, Detection and Deterrents

Narendra P. Sarda13th December, 2007

©2003 Firm Name/Legal Entity

Corporate Fraud

Fraud

Fraud is generally described as an intentional or

deliberate act to deprive another of property or

money by deception or other unfair means.

It is further defined, with respect to financial

reporting, as an intentional act that results

in a material misstatement in the financial

statements.

Types of Frauds

Category Examples

Asset

Misappropriation

•Fraudulent invoicing

•Check tampering

•Identity theft

•Loans on overvalued or fictitious properties

•Misrepresenting income and/or work history

Corruption • Accepting bribes

• Extortion

• Illegal gratuities

Types of Frauds

Category Examples

Fraudulent

Statements

• Concealed liabilities

• Improper asset valuations - current / fixed assets

• Fictitious revenues

• Improper disclosures

• Timing differences

What fraud schemes are most common?

• Revenue recognition fraud schemes are by far the most prevalent, at 41% of the total. This finding is consistent with earlier studies and reinforces the need for focus on this area.

• Other fraud schemes involving manipulation of various financial statement items account for more than a third of all fraud schemes identified.

Category Cases %*

Median Loss

Asset

Misappropriation

1,038 91.50% $150,000

Corruption 349 30.80% $538,000

Fraudulent

Statements

120 10.60% $2 million

Corporate Fraud - Impact

Why Fraud?

•As the power of business concern expands, so does the potential use of power

•Excess of Management Power

•Misuse of Executive Power

•Personal Gains

•A Culture of Competition which spurs and motivates rule breaking

•Short Termism(Short term objectives of good results instead of long term sustainibility.)

•Corporate frauds are manifestation of the failure of corporate governance mechanism

Organizational Vulnerability

• Internal controls are weak

• Absence of Internal Audit function

• The company is dominated by few at the top

• Employees are poorly paid, have low moral and are overworked

• Decentralized structure with numerous remote locations

• Management compensation linked to short term results

• Company operates in an industry with many failures or instances of fraud

• Company is experiencing financial difficulties and diminishing cash flow

• High employee turnover rate, especially in the accounting function

• Poor accounting records

• Company is losing market share and struggling to meet analysts estimates

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Global Examples

Global Trends

White collar crime, fraud, corruption and the stewardship in the corporate sector had always been thought to exist in the past. But their magnitude in the present times has assumed alarming proportion and jeopardized the very existence of corporate organizations.

The Bank of Credit and Commerce International (BCCI), the World’s 7th largest bank with 400 branches in 70 countries had to be closed down by the Bank of England in 1991 for proven cases of money-laundering, bribery, corruption, evasion of foreign exchange regulations, falsification of accounts, misappropriation of depositors money, black mail and massive fraud.

Baring a reputed merchant bank with over 200 years of lineage went bust in 1995 on account of arrogance, corporate greed, management failure and supervisory incompetence.

TYCO International

• Three former executives of the company were indicted of undertaking actions that robbed US$ 600 million from the company. The alleged actions included misappropriation of assets by taking interest free loans or low interest loans from the company, some of which were later forgiven and classified as bonuses.

• Other allegations include selling of 7.5 million shares of the company for US$ 430 million without disclosing the same to the investors and evasion of sales tax on items bought with inappropriate company loans.

• Due to these charges, it market cap fell by over $ 100 billion.

Worldcomm

• The Company improperly booked operating expenses of US$ 3.8 billion as capital expenses over a period of five quarters. The cash flows were overstated. The Company gave the Chief Operating Officer an off-the-books loan of US$ 400 million. The accounts were adjusted to meet up to stock market expectations. The Securities and Exchange Commission filed a civil suit against the Company with a charge of fraud. The company filed for Chapter 11 bankruptcy. 17,000 employees were laid off.

• Its market capitalisation came down from $115 billion in 2000 to less than $ 1 billion due to alleged misconduct.

American Rice

• Two officers of the company allegedly violated the Foreign Corrupt Practices Act, 1977 by bribing Haitian officials US$ 500,000 in order to reduce the company’s import taxes by US$ 1.5 million in 1998 and 1999. The Department of Justice, USA brought criminal proceedings against both the officers of the company. The officers were sentenced to imprisonment for a period of more than 63 months and 37 months respectively. Thereafter, anti-bribery legislation has been substantially strengthened by Securities and Exchange Commission.

Riggs Bank

• A Bank pleaded guilty to a criminal charge of failing to report suspicious transactions in the accounts of foreigners, including dictators, and agreed to a $16 million fine.

• A Washington bank that drew prestige from its nearly exclusive franchise on business with the capital's diplomatic community, was fined$25 million by a Treasury Department agency. The civil fine was for alleged violations of laws to prevent money laundering in its handling of millions of dollars in the accounts controlled by foreign diplomats and officials.

Corporate Fraud - Cases

Global Crossing - has been suspected of selling its telecom capacity in a way that artifically boosted its 2001 cash revenue besides selling stocks worth $700 million soon before bankruptcy filing.

Adelphia Communications - Failed to properly disclose $2.3 billion of guaranteed loans to members of its promoters (Rigas) family. As a consequence, its stock price collapsed 99.6 per cent per share.

Lucent Technologies - Revised revenues by $679 million in fiscal 2000

Corporate Fraud - Cases

Other cases include AOL Time Warner, Bristol Myers, Elan, Hallisburton, IM CloneSystems, Microstrategy,Network Associates, PNC Financial, Qwest, Reliant Resources, Rite Aid, Vivendi Universal, Excel energy, Xerox,etc.

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Preventive & Detective

Measures of Fraud

Detection v/s Deterrence / Prevention

There is a reduced tolerance to fraud and non-ethical behaviour as well a clear shift from reactionary measures in combating fraud to proactive measures in mitigating the fraud risk.

Deterrents to Fraud

• Internal controls

• Internal audit

• Surprise audits

• Investigations

• Willingness to punish

• Detection and Investigation

• Code of Ethics

• Code of Conduct for the employee

• Code of Corporate Governance for management

• Effective Audit Committees

• Training

• Tone at the Top

Corporate Fraud - Who is watching?

Rating Agencies and Market Analysts

Law Enforcement

Institutional InvestorsCompetitors

Regulators

Stakeholders / Media

Preventive Measures

Culture of Honesty and Ethics

• Setting the tone at the top

• Creating a Positive Work Place Environment

• Hiring and Promoting Appropriate Employees

• Continuous Training

• Notification and Confirmation

• Discipline

Preventive Measures

Evaluating Antifraud Processes and Controls

• Identifying and Measuring Fraud Risks

• Mitigating Fraud Risks

• Implementing and Monitoring Appropriate Internal Controls

• Designing and putting into practice Anti Fraud Programs and Controls

• Background checks for employees / third parties who have access to sensitive information or restricted areas

IT access Controls

• Revised Auditing Standards

Preventive Measures

Appropriate Oversight Process – In the Organisation

• Audit Committee or Board of Directors• Management• Other oversight resources like internal or external auditors or

a certified fraud examiner.

• Audit (Special) Committee has an obligation to answer at least three critical questions:

– Did wrongful conduct occur (and if so, to what extent and effect)? – Have all reasonable steps been taken to address the effects of the

company’s wrongful conduct?– What assurances does the board have that similar misconduct will

not recur?

Potential Remedial Actions – Create the Right Tone

•Avoid:

–Unusual business practices

–Aggressive accounting methods

–Earnings management issues

–A culture of pressure on the numbers

–Violations of company rules and regulations as well as code of conduct

USA Scenario

•The Sarbanes Oxley Act 2002 has taken the following steps to deal with corporate misdemeanours

–Further empowering Securities Exchange Commission (SEC)

–Establishment of Public Companies Accounting Oversight Board (PCAOB)

–Enhanced financial disclosures–Stringent punishment for corporate misconduct

•Public Debate on Cost/Benefit analysis of excessive legislation (SOX)

USA Scenario

•Despite increasingly stringent legislation such as the Foreign Corrupt Practices Act and the Sarbanes Oxley Act aimed at combating fraud – and despite increased enforcement efforts by the SEC financial statements fraud remains a public concern.

•SEC has issued (from 2000 through 2006) 344 financial statement fraud AAERs (Accounting and Auditing Enforcement Releases)

77 in 2003 (peak)

Now – 50 – Average Annual Rate

Often identified multiple fraud schemes

Major Item - Revenue Recognition – 41%

Indian Scenario

1.The fraud risk perceived to be highest for the financial sector

(Banking, insurance, mutual funds, asset management companies, NBFC’s and Investment banks)

Bank Scam – 1991 – 1992

Stock Echange Scams

2. Next – Telecom, Media and Technology (TMT).

3. Caro 2003 – Clause 4 (xxi)

Maximum cases – employees asset misappropriation

Indian Scenario

• Clause 49 – Reporting on assessment of the effectiveness of internal controls that mitigate fraud risks.

• Director’s Responsibility Statement (Sec 217 (2A))

• Lack of

a. Formal Training

b. Formal Fraud Response Plan

Indian Scenario

Nareshchandra Committee – recommended

a) Measures for Corporate Governance

b) Audit Quality Board (now Constituted)

c) Serious Fraud Investigation Office – SFIO

(already set up by Min of Co. Affairs)

SFIO will investigate frauds characterised by

(i) Complexity and having inter-departmental and multi-disciplinary ramifications

(ii) Substantial involvement of public interest in terms of misappropriation and number of persons affected, and

(iii)Possibility of investigations leading to clear improvement in systems, laws and procedures. It will investigate only “corporate frauds”. The SFIO will consist of expert in the field such as accountancy, forensic, auditing, taxation, IT, capital market, etc.

Measures by ICAI

•Formulation and Implementation of Accounting and Auditing Standards – Convergence with IFRS

•Peer Review Board

•Financial Reports Review Board

•Independent Audit Qulaity Board

Corporate Fraud – Detection

Detection Methods– 34% Tips, Anonymous calls – 25% By Accident– 20% Internal Audit– 19% Internal Controls– 12% External Audit– 4% Notified by Police* The sum of percentages exceeds 100% because several cases involved fraud schemes that fell into more than

one category.

Fraud Detected – Disclosure Obligations

•The company may be required to make an announcement to the market.

•Liaise with internal/external counsel concerning Listing Rules.

•Always bear in mind any disclosure requirements in other jurisdictions and whether there could be a requirement to restate the financial statements.

•Consider any requirement to make disclosures to the relevant regulators and to comply with the money laundering legislation.

•Consider the need to make internal disclosures e.g. to the Audit Committee.

Fraud Investigation – Initial Steps

•Management can perform important initial steps including:

– Consider the allegation

– Quantity and quality of information known

– Who is alleged to be involved

– Seriousness of conduct

– Gather information

– People and parties who will need to be involved

(whether outside professional services are necessary?)

– Background interviews of relevant employees

Best Practice: Have a clear defined process in place for each type of matter including sufficient documentation

Initial Assessment – Common Mistakes

•Underestimate the allegation– Can’t be material in size

•First steps are inappropriate & insufficient– Too slow to take appropriate action

– “We can handle it”

– This is an internal matter – we will keep in “our house”

•Lack of consideration to important factors (e.g. independence, privilege, preservation of documents etc.)

•Underestimate internal human resource issues – Amount of time

– Effect on morale

•Do not involve outside assistance early enough

•Do not involve external auditors early enough

Forensic Services(rendered by professional Firms)

Fraud and misconduct diagnostic reviews

Forensic technology services

Corporate Intelligence

Pre-emplyment background check

Dispute resolution

Litigation support and expert witness services

Contract Compliance Services

Supply chain integrity

Asset Tracing