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Understanding & Managing Fraud Rrisk

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This presentation is an overview of Fraud Risk Management in Indian companies and the role of the Board of Directors in the context of the newly enacted Companies Act, 2013.

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Understanding & Managing Fraud Rrisk

  1. 1. Understanding & Managing Fraud Risk ENHANCING BOARD PERFORMANCE November 16th 2013, Kolkata 1
  2. 2. Corporate fraud – a working definition Corporate fraud occurs when: • An employee violates his/her fiduciary duties towards the organization. • Is done in secret and is concealed. • Is done for a direct or indirect benefit to the perpetrator. • Costs the organization, its assets, revenue, or opportunities. …………….. also referred to as Occupational fraud or Internal fraud. 2
  3. 3. Classification* of fraud in organizations *adapted from ACFE 2012 Report to the Nations on Occupational Fraud and Abuse. 3
  4. 4. How Occupational Fraud is Committed Occupational Frauds by Category — Frequency Source : ACFE 2012 Report to the Nations on Occupational Fraud and Abuse. 4
  5. 5. How Occupational Fraud is Committed Occupational Frauds by Category — Median Loss Source : ACFE 2012 Report to the Nations on Occupational Fraud and Abuse. 5
  6. 6. Why frauds take place-the Fraud Triangle Pressure Medical bills, expensive tastes, addiction problems to Commit fraud Rationalization (Attitude) Every one does it. Simply borrow the money Opportunity due to weak and override of controls Trusted persons become trust violators when they conceive of themselves as having a financial problem which is nonshareable, are aware this problem can be secretly resolved by violation of the position of financial trust, and are able to apply to their own conduct in that situation, verbalizations which enable them to adjust their conceptions of themselves as trusted persons with their conceptions of themselves as users of the entrusted funds or property.1 1Donald R. Cressey, Other People's Money (Montclair: Patterson Smith, 1973) p. 3 6
  7. 7. The Fraud Triangle……..contd. PRESSURE: This is what causes a person to commit fraud. This includes medical bills, expensive tastes, addiction problems, significant financial needs etc. Often this need/problem is non-discloseable in the eyes of the fraudster. That is, the person believes, for whatever reason, that their problem must be solved in secret. OPPORTUNITY: Opportunity is the ability to commit fraud. Because fraudsters don’t wish to be caught, they must also believe that their activities will not be detected. Opportunity is created by weak internal controls, poor management oversight, and through abuse of power. RATIONALIZATION: It occurs when the individual develops a justification for their fraudulent activities. The rationalization varies by case and individual. Some examples include: – “I really need this money and I’ll pay it back when I get my salary” – “Other people are doing it” – “I didn’t get a raise. The Company owes me.” 7
  8. 8. The Fraud Triangle…..….contd. Breaking the Fraud Triangle is the key to fraud deterrence. Breaking the Fraud Triangle entails removing one of the elements in the fraud triangle in order to reduce the likelihood of fraudulent activities. Of the three elements, removal of opportunity is most directly affected by the system of internal controls and generally provides the most actionable route to deterrence of fraud. 8
  9. 9. Detection of Fraud Schemes Initial Detection of Occupational Frauds Source : ACFE 2012 Report to the Nations on Occupational Fraud and Abuse. 9
  10. 10. Dimensions of fraud in India Inc. •The occurrence of fraud is almost equally poised between public and private limited companies • Most of the companies have medium scale of operations with the average revenue size of less than Rs 200 crores. • Further, in 80% of the cases, the size of the fraud was less than Rs 200 crores. However, the average revenue size of these companies has increased 7.25 times in the period after 2009, exposing larger number of stakeholders to risks of corporate failure • Fraud risk is pervasive across all the industry sectors with manufacturing sector accounting for one out of three cases highlighting the need for appropriate fraud policies across all the sectors •Significant spurt not only in the number of fraud cases but also in their size after 2009 with an average size of fraud almost doubling since 2009. Source: Thought Arbitrage Research institute, New Delhi ,Understanding the Demand and Supply Equations of Corruption and Fraud (an in-depth analysis of 100 major corporate frauds that occurred over the last 15 years), 2012. 10
  11. 11. Dimensions of fraud in India Inc…contd. • Most fraudulent transactions were designed to either siphon of the companies funds by promoters or top management or to defraud government/ investors/ lenders. One of the key contributing factors for corporate fraud in India is the control and concentration of promoters, whether families or MNC’s, at the helm of affairs. Such controls over all aspects of business are often abused for personal gains at the cost of other stakeholders • Fraud techniques used in last 15 years have not undergone much sophistication. Most of frauds in the study perpetrated through recording of assets at a value higher than their fair value or alternatively by a web of book entries through related party accounts to embezzle. This also points towards existence of control weaknesses that give perpetrators of the fraud an ‘opportunity’ to commit such a fraud Source: Thought Arbitrage Research institute, New Delhi ,Understanding the Demand and Supply Equations of Corruption and Fraud (an in-depth analysis of 100 major corporate frauds that occurred over the last 15 years), 2012. 11
  12. 12. Dimensions of fraud in India Inc…contd. • No significant cases came to light where the auditors have been able to detect such fraud in the course of their audits, reflecting poorly on the watchdogs (i.e. internal, statutory and tax auditors) who take their cues from the gatekeepers i.e. regulators. The auditors should have been the first ones pointing out most of these frauds in the financial statements because the schemes for committing fraud do not seem to be too sophisticated or complex • Number of frauds in the our study are equally distributed among firms audited by the Big 4 and Non-Big 4 auditors indicating that detection of fraud is hard even for large auditing firms • Presence of earnings management can be construed to be a potential indicator of presence of financial statement fraud Source: Thought Arbitrage Research institute, New Delhi ,Understanding the Demand and Supply Equations of Corruption and Fraud (an in-depth analysis of 100 major corporate frauds that occurred over the last 15 years), 2012. 12
  13. 13. Dimensions of fraud in India Inc…contd. • Majority of the companies involved in fraud have either been liquidated or their business has been discontinued or are continuing at reduced levels with market valuations drastically reduced • The study did not comment conclusively on the adequacy or otherwise of the penalties/fines imposed due to lack of adequate public information. There seems to be an inadequate enforcement of laws and deterrence for committing frauds. These frauds seem to be carried out with impunity as the chances of getting caught are minimal and the quantum of fine and punishment is not a valid deterrence ensuring them to retain the spoils of the fraud as personal wealth. • Effectiveness of Clause 49 of Listing Agreement (corporate governance code for all for public listed companies) covenants on fraud occurrence, detection and prevention is very limited Source: Thought Arbitrage Research institute, New Delhi ,Understanding the Demand and Supply Equations of Corruption and Fraud (an in-depth analysis of 100 major corporate frauds that occurred over the last 15 years), 2012. 13
  14. 14. Fraud and Corruption: Mechanics and Perspectives • Various ways through which transfer of funds takes place during fraud and corruption includes: loan transactions, related party transactions, especially structured transactions, payments made through agents/ distributors, payments made to trusts, transfer of assets at value other fair market value. • From MCA perspective, SFIO points that four different types of frauds: financial statement fraud, capital market fraud, fraud in project funding, fraud through fake invoices and bills. • From tax regulator perspective, CBDT observes that black money is generated either through manipulation of accounts or through out of book transactions. • From the US securities market regulator – SEC perspective corporate frauds mainly takes place through improper revenue recognition, overstatement of existing assets, and capitalization of expenses. Source: Thought Arbitrage Research institute, New Delhi ,Understanding the Demand and Supply Equations of Corruption 14 and Fraud (an in-depth analysis of 100 major corporate frauds that occurred over the last 15 years), 2012
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  17. 17. Perpetrators of Fraud in India Source: Ernst & Young, India Fraud Indicator 2012. 17
  18. 18. Mode of detection of Fraud in India Inc. 1. Whistle Blower/Ethic hotline. 2. Internal Audit review. 3. Data Analytics. 4. IT Controls. 5. Anonymous letter/call/tip off. 6. Business Partner/vendor/Third party complaint. 7. Statutory Audit. 8. By Accident Ranks are based on total score- Rank 1 is most effective. Source: KPMG, India Fraud Survey, 2012. 18
  19. 19. Role of the directors in preventing fraud The directors on the board of scam-tainted Satyam Computer acted as "rubber stamps" and "not even a single dissent note was recorded" during the board meetings, a CBI official said on Saturday. "Meetings were conducted in a perfunctory manner. The promoters were always present to influence the decision. There were no open discussions," RBI General Manager, currently on deputation with the CBI, J L Negi said at a CBI Workshop here*. *http://articles.economictimes.indiatimes.com/2010-07-10/news/27599841_1_satyam-directors-rubber-stamp-g-ramakrishna 19
  20. 20. Foundation for Fraud Risk Management To ensure a proper foundation for the organization’s fraud risk management activities, the board should work closely with management to clearly define and formally record the following in the organization’s antifraud policy or fraud risk management policy: • The board’s expectations of management in managing fraud risks • The specific responsibilities of both the board and management for fraud risk management • The ownership of risks at the executive, senior manager, and business-unit manager levels • The overarching objectives of the fraud risk management program Source : The Conference Board, The Role of the Board in Fraud Risk Management, October 2011. 20
  21. 21. Role of the Board in Fraud management The Board has the responsibility to ensure that management designs effective fraud risk management documentation to encourage ethical behavior and to empower employees, customers and vendors to insist those standards are met every day. The Board should; • Understand fraud risk •Maintain oversight of the fraud risk assessment by ensuring that fraud risk has been considered as a part of the organization’s risk and strategic plans. This responsibility should be considered under a periodic agenda item at board meetings when general risks to the organization are reviewed. Source: The Institute of internal Auditors, American Institute of Certified Public Accountants and Association of Certified Fraud Examiners, Managing the Business risk of Fraud: A practical guide, 2006. 21
  22. 22. Role of the Board in Fraud management….contd. • Monitor management’s reports on fraud risks, policies and control activities which include obtaining assurances that the controls are effective. The Board should also establish mechanisms to ensure it is receiving accurate and timely information from management, employees, internal and external auditors and other stakeholders regarding potential fraud occurrence. • Oversee the internal controls established by the management. • Set the appropriate tone at the top by CEO job description, hiring, evaluation and succession planning processes. • Have the ability to retain and pay outside experts whenever needed. • Provide external auditors with evidence regarding the board's active involvement and concern about fraud risk management. Source: The Institute of internal Auditors, American Institute of Certified Public Accountants and Association of Certified Fraud Examiners, Managing the Business risk of Fraud: A practical guide, 2006. 22
  23. 23. Fraud & the Companies Act, 2013 • “Fraud” and “Wrongful gain” have been defined for the first time, apart • • from penalties; punishment for fraud involving imprisonment, which is now introduced in many cases. The Act makes companies and its officers more accountable and brings new concepts to better regulate companies. From shareholders’ rights (class action suits) to greater duties of independent directors in scrutiny of related party transactions and its disclosures (Board now has to justify them), from rotation of auditors (with maximum tenure of five years for an auditor) to mandatory formation of vigil mechanism (whistle blowing mechanism), by listed companies and introduction of stringent penal provisions for fraud or wrongful acts or contravention of any provisions in the law are some of the highlights of the Act. Auditors (including, Cost Accountants for Cost Audit and Company Secretary in Practice for Secretarial Audit), during the course of performance of its duties, are required to immediately report to the Central Government, any offence involving fraud that is being or has been committed against the company by its • officers or employees. The legislation also grants statutory powers to SFIO to tackle corporate frauds. The SFIO will get a big fillip, now that the Act has come into force. 23
  24. 24. Detecting Fraud and Corruption: Challenges and Way Forward Perspectives • The Government of India initiatives, such as RTI Act 2005 and on egovernance, constructive role played by the CAG of India, and greater judicial involvement have been some of the steps towards coping with widespread corruption prevalent in the last century in India. However, challenges still persist. • In India, multiple regulators, such as SEBI, MCA, and RBI exist with overlapping domains. • Significant challenges prevail in the Indian legal and regulatory system: – enforcement of contracts and delay in the judicial system, low conviction rate of corrupt people, multiplicity of regulators and investigating agencies and – lack of skilled resource person. • The way forward to deal with corruption – leveraging technology, more skilled resources for investigating agencies, better co-operation and coordination between multiple agencies, greater efficiency of the judicial system. Source: Thought Arbitrage Research institute, New Delhi ,Understanding the Demand and Supply Equations of Corruption and Fraud (an in-depth analysis of 100 major corporate frauds that occurred over the last 15 years), 2012. 24
  25. 25. Further reading • • • • • • Understanding the Demand and Supply Equations of Corruption and Fraud -An insight into the Corruption and Fraud by the private sector in India, Thought Arbitrage Research Institute, New Delhi, 2012, available at http://www.tari.co.in/public/report/1372144861Understanding%20the%20demand%20&%20suppl y%20equations%20of%20corruption%20&%20fraud%20-%20final.pdf India Fraud Indicator 2012 -Increasing magnitude of fraud , A study by Ernst & Young’s Fraud Investigation & Dispute Services, available at http://www.ey.com/IN/en/Services/Assurance/Fraud-Investigation---Dispute-Services/India-FraudIndicator-2012. India Fraud Survey, 2012, KPMG available at http://www.kpmg.com/IN/en/IssuesAndInsights/ArticlesPublications/Pages/FraudSurvey12.aspx Report to the Nations on Occupational Fraud and Abuse -2012 Global Fraud Survey, Association of Certified Fraud Examiners, available at http://www.acfe.com/uploadedFiles/ACFE_Website/Content/rttn/2012-report-to-nations.pdf. Corporate Resiliency: Managing the growing risk of fraud and corruption -A holistic approach, Deloitte Forensic India in collaboration with FICCI, available at http://www.ficci.com/spdocument/20310/FICCI-Deloitte.pdf. The Role of the Board in Fraud Risk Management –Director’s Notes, The Conference Board, available at http://www.conference-board.org/retrievefile.cfm?filename=TCB-DN-V3N2125 111.pdf&type=subsite
  26. 26. Please visit my Author’s page at http://ssrn.com/author=1714442 for access to my papers and research on Corporate Governance with specific reference to India. Comments and views are welcome at spande@nihilent.com 26
  27. 27. THANK YOU 27

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