Fraud, corruption risk higher during economic downturn?

FRAUD and corruption risk: Is the risk higher in tough economic times?

The short answer to this question is “yes”.

History, if we choose to learn from it, provides much support for the premise that fraudulent activities increase in an economic downturn. A 2008 research study (Research Advisory Board Study), conducted on a sample of the Securities and Exchange Commission’s Accounting and Auditing Enforcement Releases filed from 1982 to 2005, found that most financial statement manipulations occurred in 1999 and 2000, during the economic downturn, partly caused by the bursting of the dotcom bubble.

In July 2008, Deloitte’s Financial Advisory practice in the United States conducted a survey on financial fraud in an economic downturn and asked 1,500 participants a series of questions. When asked what they believed “will be the trend for the number of accounting frauds uncovered in the next two years,” a majority of over 1,400 respondents (63%) said it would increase.

So, what are the preconditions for fraud and corruption? There are three elements that have a direct impact on the incidence of fraud and corruption – financial pressure, opportunity and rationalisation.

Financial pressure: In tough times, the financial pressure on businesses is heightened when there are expectations, realistic or otherwise, for continued growth or achieving and even exceeding financial targets. When bad news is on the horizon, management may become more adventurous in its accounting practices, particularly in areas requiring management judgment. When wages increase marginally or not at all while the cost of living increases, employees will feel greater pressure on their personal finances. This can lead to an increase in asset misappropriation.

Opportunity: In an environment of rationalisation and cost cutting to preserve profit, resources can often be diverted from prevention and detection initiatives, such as effective implementation of internal controls. Downsizing could lead to lack of resources and poor segregation of duties. This ultimately can weaken or eliminate internal controls.

Rationalisation: A combination of financial pressure and opportunity makes it far easier for management and employees to rationalise fraudulent or corrupt behaviour. If employees feel that their jobs are on the line, they may feel they have nothing to lose. Management, on the other hand, may rationalise fraudulent activity such as account manipulation or sanctioning the payment of bribes to win business – believing it to be in the best interests of the company, employees and shareholders.

During the many years that I have been investigating fraud and corruption issues, many of the incidents had common characteristics or circumstances that allowed the fraud to occur. Often, the offices where the incident occurred were located far from the head-office. Geographical proximity in itself is not an issue, but when there is a lack of regular head-office or independent oversight, problems can arise.

In such cases, a dominant manager or employee in a functional area, such as an accounts department, is more likely to adopt practices outside of company policy. Staff under their control may be intimidated and reluctant to report misconduct by the employee concerned, including suspicions of fraud. It is often found that the fraudsters will be reluctant to have anyone else perform their roles or functions, for fear of being uncovered, and a common “red flag” is the person’s unwillingness to take annual leave.

Quite often there is a lack of appropriately qualified and experienced accounting personnel to allow for adequate segregation of duties or to conduct fundamental tasks such as regular bank account reconciliations.

When all of these circumstances co-exist, it creates a highly conducive environment for fraud to occur.

Is there a solution?

Unfortunately, where people are involved in anything, one cannot totally eliminate the risk of fraud. We can, however, reduce the likelihood of it occurring if steps are taken to adopt a co-ordinated approach to controlling it. A clearly thought-out strategy and approach, in the form of a fraud and corruption control framework, is essential.

Underpinning this framework, there should be a clearly articulated zero-tolerance policy on fraud and corruption. There should be visible and unequivocal management commitment to the policy; and a high level of awareness within the organisation of the policy, current fraud and corruption schemes and the “red flags” or indicators of fraud.

In the event that fraud does occur, there should be measures to detect it at the earliest possible time. Some of these measures might include targeted transaction reviews and the use of data analytics. The beauty of data analytics is that 100% of data can be analysed within a short timeframe to identify anomalies for further follow-up. Another fundamental prevention and detection measure is the implementation of an anonymous reporting mechanism such as a hotline for employees to report suspicions of fraudulent conduct. Ideally, this should be independent and offer 24/7 access.

Incident response procedures that outline how and by whom incidents of fraud and corruption should be dealt with, and clear reporting lines – both internal and external – should be in place.

While there is a cost involved in implementing measures to prevent and detect fraud, this cost pales into insignificance when compared with the cost of investigating fraud and corruption incidents.

The old adage, “an ounce of prevention beats a pound of cure”, rings true, and from a governance and reputational standpoint, is a necessary cost of doing business.

● The writer is the head of Deloitte Malaysia’s forensic practice.

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