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Corporate Frauds:

Prevention, Detection and Deterrents

Narendra P. Sarda

13thDecember, 2007

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2003 Firm Name/Legal Entity

Corporate Fraud

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Types of Frauds

Category Examples

Asset

Misappropriation

Fraudulent invoicing

Check tampering

Identity theft

Loans on overvalued orfictitious properties

Misrepresenting incomeand/or work history

Corruption Accepting bribes

Extortion

Illegal gratuities

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Types of Frauds

Category Examples

Fraudulent

Statements

Concealed liabilities

Improper asset valuations -current / fixed assets

Fictitious revenues

Improper disclosures

Timing differences

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Category Cases %*MedianLoss

Asset

Misappropriation1,038 91.50

% $150,000

Corruption 349 30.80% $538,000

Fraudulent

Statements120 10.60

%$2 million

Corporate Fraud - Impact

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Why Fraud?

As the power of business concern expands, so does

the potential use of powerExcess of Management Power

Misuse of Executive Power

Personal GainsA Culture of Competition which spurs and motivates

rule breaking

Short Termism

(Short term objectives of good results instead of long termsustainibility.)

Corporate frauds are manifestation of the failure of

corporate governance mechanism

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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 instancesof 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 analystsestimates

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Global Examples

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Global Trends

White collar crime, fraud, corruption and the

stewardship in the corporate sector had always beenthought to exist in the past. But their magnitude inthe present times has assumed alarming proportionand jeopardized the very existence of corporateorganizations.

The Bank of Credit and Commerce International (BCCI), the Worlds7thlargest bank with 400 branches in 70 countries had to be closeddown 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 depositorsmoney, black mail and massive fraud.

Baring a reputed merchant bank with over 200 years of lineage wentbust in 1995 on account of arrogance, corporate greed, managementfailure and supervisory incompetence.

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TYCO International

Three former executives of the company were

indicted of undertaking actions that robbed US$600 million from the company. The allegedactions included misappropriation of assets bytaking interest free loans or low interest loansfrom the company, some of which were laterforgiven and classified as bonuses.

Other allegations include selling of 7.5 millionshares of the company for US$ 430 millionwithout disclosing the same to the investors and

evasion of sales tax on items bought withinappropriate company loans.

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

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Worldcomm

The Company improperly booked operating

expenses of US$ 3.8 billion as capital expensesover a period of five quarters. The cash flowswere overstated. The Company gave the ChiefOperating Officer an off-the-books loan of US$400 million. The accounts were adjusted to meet

up to stock market expectations. The Securitiesand Exchange Commission filed a civil suit againstthe Company with a charge of fraud. Thecompany filed for Chapter 11 bankruptcy. 17,000employees were laid off.

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

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American Rice

Two officers of the company allegedly violated theForeign Corrupt Practices Act, 1977 by bribing

Haitian officials US$ 500,000 in order to reducethe companys import taxes by US$ 1.5 million in

1998 and 1999. The Department of Justice, USAbrought criminal proceedings against both the

officers of the company. The officers were

sentenced to imprisonment for a period of morethan 63 months and 37 months respectively.

Thereafter, anti-bribery legislation has been

substantially strengthened by Securities and

Exchange Commission.

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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. Thecivil fine was for alleged violations of laws to

prevent money laundering in its handling of

millions of dollars in the accounts controlled byforeign diplomats and officials.

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Corporate Fraud - Cases

Global Crossing - has been suspected of selling its

telecom capacity in a way that artifically boosted its2001 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 $679million in fiscal 2000

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Corporate Fraud - Cases

Other cases include AOL Time Warner,Bristol Myers, Elan, Hallisburton, IM

CloneSystems, Microstrategy,NetworkAssociates, PNC Financial, Qwest,Reliant Resources, Rite Aid, VivendiUniversal, Excel energy, Xerox,etc.

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Preventive & Detective

Measures of Fraud

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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

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Corporate Fraud - Who is watching?

Rating Agencies andMarket AnalystsLaw Enforcement

Institutional InvestorsCompetitors

Regulators

Stakeholders / Media

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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

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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 atleast 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 thecompanys wrongful conduct?

What assurances does the board have that similar misconduct willnot recur?

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Potential Remedial Actions Create theRight 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

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USA Scenario

The Sarbanes Oxley Act 2002 has taken thefollowing steps to deal with corporatemisdemeanours

Further empowering Securities ExchangeCommission (SEC)

Establishment of Public Companies AccountingOversight Board (PCAOB)

Enhanced financial disclosures

Stringent punishment for corporate misconduct

Public Debate on Cost/Benefit analysis of excessivelegislation (SOX)

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USA Scenario

Despite increasingly stringent legislation such as the

Foreign Corrupt Practices Act and the SarbanesOxley 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%

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Indian Scenario

1.The fraud risk perceived to be highest for the

financial sector(Banking, insurance, mutual funds, asset management

companies, NBFCs 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 assetmisappropriation

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Indian Scenario

Clause 49 Reporting on assessment of theeffectiveness of internal controls that mitigate fraud

risks.

Directors Responsibility Statement (Sec 217 (2A))

Lack of

a. Formal Training

b. Formal Fraud Response Plan

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Measures by ICAI

Formulation and Implementation of Accounting andAuditing Standards Convergence with IFRS

Peer Review Board

Financial Reports Review Board

Independent Audit Qulaity Board

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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.

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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 inother 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 moneylaundering legislation.

Consider the need to make internal disclosures e.g.

to the Audit Committee.

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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 involvedSeriousness 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 ofmatter including sufficient documentation

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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

Documents

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