Cancerous growth of corporate frauds By Muhammad Bashir Chaudhry

The incidence of corporate frauds has swelled in India mainly because of ineffective control systems and diminishing ethical values, according to Fraud Survey Report 2010. The situation in corporate Pakistan may not be very different.

To quote the State Bank of Pakistan data, some 10 per cent increase in fraud and forgery was recorded in the banking system during July-September 2009 as compared to the previous quarter.

The survey reports issued by the KPMG and other experts in India or elsewhere in a way are cancer-like research findings, which offer a set of parameters as to how one can increase chances of avoiding corruption. Control of fraud requires vigilance, at all levels and at all times, supported by scientific tools in the hands of experts. The first step, however, is to understand the nature of fraudulent activities and that of persons who could possibly indulge in such acts.

Fraud has different connotations and is defined as such. One simple definition of fraud is that it is an act or course of deceit deliberately practiced to gain unlawful or unfair advantage.

Corporate fraud is when a corporate entity is involved, though the discussion here is equally applicable to proprietorships, partnerships, trusts and associations. Corporate fraud or unethical activities are divided in three broad categories.

The first category is where a company acts fraudulently or unethically to gain unlawful advantage or benefit by harming or undermining the lawful interest of the government by indulging in evading taxes, smuggling, mis-declarations, valuation frauds, fraudulent claims of refund and rebate etc. Such a company may be committing an economic crime and gaining financially at the cost of the government and consequently the general public. A sample of some of the similar instances is given below:

a) A company producing consumer, intermediate or capital goods or offering services may be promoting its sale at higher prices, offering underhand payments, commissions or kickbacks to the influential persons possibly in the purchase departments of the government or the buyer companies.

b) A company can sometimes benefit from laws, rules, regulations, policies or entities partly developed by undue influence of certain vested interests for their own private benefit.

c) Bribery and corruption have come to be viewed as an inevitable aspect of doing business. Corporate hospitality is one such practice.

d) The company manipulates, against the prescribed rules, its periodic financial statement with the intent of hoodwinking the creditors or the investors while mobilising additional loans or investments. Distortions may be made through acts such as overvaluing of assets, creating fictitious revenue, concealing of liabilities and expenses, deferring expenses, improper revenue recognition, inappropriate omissions or disclosures, hiding conflicts of interest situations or capitalising operating expenses and use of related party transactions to shift profits or losses. The practice of some banks showing loans at lower level on the dates of the quarterly or annual accounts meant for general public, and thus indicating the lower credit risk is also a case in point.

e) Conflict of interest related frauds in the corporate sector, such as awarding contracts to favourites, kickbacks, double book keeping, etc. Actions resulting from conflict of interest generally constitute most costly frauds, since these happen at senior management / governance level.

The second category of corporate fraud is where the company is a victim of the fraudulent activities perpetrated by its employees alone or with the connivance of outsiders or mainly by the outsiders possibly with information or tips passed on by any employee.

The perpetrators of fraud could theoretically be a member of the board, chief executive, member of the senior management team or a lower level employee. Every company is exposed to the risk of fraud in case it has inadequate internal controls, management in the habit of overriding internal controls, ineffective compliance programmes and weak oversight of management by the directors.

The company may be defrauded in various ways such as fictitious medical claims, bid rigging, conflicts of interest, diversion of sales, asset misappropriation, kickbacks in purchases or award of contracts, payroll embezzlement and abuse of expense account.

The employees at lower echelons in a company may perhaps fall prey to the temptation of committing fraud if they see use of company resources for personal gain by members of the board, top management or the members of the group controlling the company, practices that are not entirely legal or ethical.

It is generally easier for an employee to commit fraud as he is aware of the processes and internal controls and it is easier for him to circumvent the controls. The earnings of some top executives are linked to the financial performance of a company; such employees at times resort to cooking up the books.

Certain companies believe that they can detect and control all corporate frauds by employing trustworthy staff, instituting controls and engaging the auditors. These are only myths. According to experts, the reality is that it is the trusted employees who commit fraud when they are given responsibility, authority and independence without adequate monitoring. Moreover, the external auditors engaged for audit of accounts are not responsible for discovering corporate frauds.

The third category of corporate fraud is when a group of people join hands in starting certain dubious investment or other quick money making scheme with the intent of cheating a targeted set of people or the public at large. They may use fake logo or fake letterheads of companies or misrepresent known companies.

The banking and corporate regulators, namely SBP and SECP keep on issuing joint public notices to warn the general public of such dubious schemes.

Measuring the true cost of fraud is not easy. Some frauds are never detected, or only discovered after they have gone on for several years. Many detected are never reported for variety of reasons, including its impact on company’s image.

Ineffective whistle-blowing systems, inadequate oversight of senior management activities by the audit committee and weak regulatory oversight mechanisms are some of the reasons for the increase in the number of frauds that one can see in corporate sector. Moreover, the incidence of frauds is increasing due to difficult economic scenario coupled with diminishing ethical values.

The authorities as well as various regulators keep on introducing new measures to minimise unethical or illegal practices. The corporate entities also try to erect firewalls to safeguard their interest against pilferage or fraud. But individuals as customers, savers or investors are in most cases at the losers’ end. This has to change.

Source: http://www.dawn.com/wps/wcm/connect/dawn-content-library/dawn/in-paper-magazine/economic-and-business/cancerous-growth-of-corporate-frauds-640