Deterrence and detection of financial fraud

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Over the past few decades, multiple headline-grabbing cases of fraud in the financial reporting of public companies have rocked capital markets. This report discusses the various areas of financial fraud risk, its impact and the regulatory framework relating to it.

Given the current state of the economy and recent corporate scandals involving global and Indian MNCs, fraud is a top concern for corporate executives. Increasing enforcement of laws such as the FCPA has exposed fraudulent practices that may have previously gone undetected.

What is fraud?

According to the Association of Certified Fraud Examiners (ACFE), fraud is “deception or misrepresentation that an individual or entity makes knowing that the misrepresentation could result in some unauthorized benefit to the individual or to the entity or some other party.”

Occurrence of frauds

Opportunity can arise from a lack of organizational controls and security; a company deficient in these areas is creating ample opportunity for fraud to occur.

Corporate fraud generally falls into one of three categories:

  • Asset misappropriation
  • Corruption
  • Financial statement fraud
In EY’s 12th Global Fraud Survey 2012, 39% of the respondents reported that bribery or corrupt practices occur frequently in their countries.

Corruption in India: a major challenge

India struggles with corruption issues both alleged and real. Corruption is frequently perceived as the way of doing business in India. According to Transparency International’s Corruption Perception Index 2012, India was ranked 94 out of 176 countries/territories, where 1 stood for least corrupt.

Common examples of corruption include:

  • Conflict of interests
  • Bribery
  • Economic extortion
  • Kickbacks

Unethical Practices seen in organizations in India
EY - Unethical Practices seen in organizations in India

Financial statement frauds

The Association of Certified Fraud Examiners (ACFE) defines financial misstatement as deliberate misrepresentation of the financial condition of an enterprise. Some of their ways to identify financial fraud schemes include:

  • Increased revenues without a corresponding increase in cash flow, especially over time
  • Significant, unusual or highly complex transactions, particularly those that are closed near the end of a financial reporting period
  • Unusual growth in the number of days’ sales in receivables
  • Strong revenue growth when peer companies are experiencing weak sales

Factors constituting fraud trends

  • Loan fraud – Borrowers may defraud banks by submitting forged property security documents, fake invoices and Chartered Accountants’ (CA) certificates to avail bank guarantees and credit facilities.
  • Tax evasion – It may be a case of willful evasion or difference of opinion, but these cases unquestionably call for further scrutiny.
  • Financial statement fraud and embezzlement –These frauds are insider jobs and the involvement of senior management results in sizeable loss to the business and financial institution.
  • Ponzi scheme – Investors greed to earn high returns in a short time makes them vulnerable to such schemes.

India’s operating environment: risk factors

EY’s EMEIA fraud Survey 2013 highlights the fact that bribery, corruption and financial misstatement are perceived as widespread in India. Hence, while India continues to be a favored investment destination, the operating environment in the country is perceived to be risk prone due to:

  • Prevailing fraud scenario
  • Lack of transparency in obtaining licenses, environmental clearances and permission makes it challenging for businesses to operate in India
  • Malpractices in logistics chains
  • Weak enforcement, delayed trials and low conviction rates embolden fraudsters

Frauds in the digital era

In recent years, the pervasiveness of IT has given rise to serious concerns relating to privacy and data protection issues. Instances of technology-led fraud have consistently been the focus area for regulators, businesses and individuals such as data theft i.e. illegal copying of information from a business or other individual.

Regulatory scenario

To outpace the evolving threats and complex frauds, the regulator and the leading companies are taking certain proactive steps. Management, boards of directors, audit committees, internal auditors, and external auditors are the parties involved in delivering high-quality financial reporting, including the deterrence and detection of fraud.

Effective compliance programs for companies

  • Creation of anti-fraud environment
  • Establishment of procedures for prevention and early detection of fraud
  • Establishment of fraud response procedures

Securing India Inc. against fraud risks

The cost of implementing a formal compliance program should be weighed against the huge price of tackling fraud and its impact. Factors organizations should consider in relation to fraud risk management:

  • Whistle-blowing mechanisms — speak-up channels
  • Training
  • Role of technology
  • Periodic assessment of risk
  • Due diligence
  • Fraud-response plan
  • Action against fraudsters
  • Enforcement of policies

Changes cannot be made overnight in companies in order to mitigate the risks of fraud, bribery and corruption.

It is essential for them to make concerted, risk-focused efforts that target areas of potential exposure, and their managements need to lead by example. This will enable them to appropriately balance their priorities of growth and ethical business conduct while seizing opportunities in these challenging economic conditions.