Nowhere to hide: Why economic pressures are turning up the heat on fraudsters

By Grant Jamieson, Partner, KPMG China

One of the consequences of the economic downturn has been the revelations of devastating, long-term fraudulent practices, some involving billions of dollars, in organisations across the world. While some organisations have been brought to their knees by fraud and malpractice, many others carry an unwitting burden of fraud within their cost base.

Fraud is often motivated by greed, but it can also be perpetuated by the financial pressures people face. As people around the world feel the effects of the downturn, some may resort to reckless or risky measures to keep their job, meet sales targets or simply maintain a lifestyle to which they are accustomed. Compounding this problem, other people within an organisation will be more likely to turn a blind eye and not report unethical practices, for fear of losing their own jobs.

The cost cutting programmes which many organisations are now indulging in run the risk of reducing an entity's anti-fraud capabilities at the time they are needed most, by removing certain checks and controls or - at the very least - diminishing their effectiveness. Companies need to be vigilant not only internally, but also externally.

Earnings management, the overstating an income stream or misstating financial records, is one of the most common forms of fraud in companies today. It can take several forms: expenses might be capitalised, sales may be recorded prematurely, or values of assets inflated. All of these actions are fraudulent activities that can be carried out by employees in relative isolation.

At the corporate level, companies can be motivated by the unprecedented pressure to stay above debt covenant levels and avoid their bankers calling their loans in . Across Asia Pacific, many companies also remain largely or partly family-owned and it is not uncommon for the owner to borrow money using that stock as collateral. This can lead to desperate owners looking to their "public" company to assist their personal finances.

Prevention can often be more cost effective than detection. Controls need to be in place and executives must lead, establishing firm ethical guidelines and educating all about fraud awareness. A recent KPMG International report identified that 89 percent of fraudsters were insiders or employees. Sixty percent were working at the mid- to senior management level.

Another finding in the report was that 49 percent of fraudsters took advantage of weak internal controls. Strong internal controls may not be able to eliminate fraud entirely, but they can make it far less likely to occur without more concerted or contrived activity between several parties.

While preventative measures need to be assessed and regularly reviewed by senior management, detection is still of prime importance. What is remarkable is how often fraud can be detected by simply looking in the right places. By asking some frank and honest questions of your own organisation, it may soon become clear where to look (see below, fraud checklist).

In the case of earnings management, malpractices can often be identified by looking at the timing of transactions. For example, there have been many cases in recent months where manufacturing companies have been found recording fictitious sales at the very end of the reporting period and then issued promissory notes to cover these sales in their financial statements. Earnings management amounts to an attempt to influence contractual outcomes that might depend on reported accounting numbers.

With employees, management, and corporations feeling greater pressure and with incidents of fraud set to rise, businesses face an environment of diminishing trust. Internal controls and external regulations are both likely to set higher requirements for transparency. This means moving away from a controls environment based on trust and disclosure to one based on demonstrative action and proof.

In large organisations, fraud and misconduct can amount to a significant and recurring cost to the business. Reduced profits and thinner margins are likely to lead to more instances of fraud generally, as well as exposing more deliberate, intentional fraud.

As organisations seek to defend fragile profit margins and mitigate the risks of more devastating losses, understanding the situations of the businesses you are partnering with, while gaining clarity and transparency in the reporting by people within your own organisation, is more important than ever.

Note: ¹ KPMG International: Profile of a fraudster, published 2008