Is fraud an equal opportunity offender?*

Companies might not be doing enough to stamp out fraud in emerging markets

*This is an expanded version of a summary that originally appeared in the October 2006 issue of CAmagazine.

By Mike Savage & Bob Ferguson

Does fraud occur more often in emerging market operations than it does in the developed world? Senior executives in many countries seem to think so, according to a recent report from Ernst & Young. But they aren’t doing what needs to be done to prevent it.

E&Y’s ninth annual global fraud report, Fraud Risk in Emerging Markets, sets out the findings of a poll of more than 500 executives in 19 countries. It shows that 60% of executives in developed markets and 86% of those in emerging markets believe the risk of fraud lies primarily in emerging markets. This isn’t surprising, given the backdrop of different industry practices, cultures, national laws and regulatory regimes. But respondents’ perceptions don’t necessarily correspond to experience. Of the 20% of companies that said they have been victims of significant fraud in the last two years, 75% experienced it in their developed market operations compared with 32% in emerging markets.

Why the gap between perception and experience? It could be argued that effective anti-fraud policies haven’t yet been properly introduced in overseas operations, along with the requisite education and training. If better internal control policies were in place, more incidences of fraud might be reported.

Internal controls need bolstering
Nearly 90% of all respondents believe their organizations’ internal controls are sufficient to identify and investigate fraud promptly.

Indeed, internal controls are good. You’d be hard-pressed to find a fraud investigator who doesn’t agree they are an important first line of defence. But on their own, they’re not enough. Companies have to supplement internal controls with formal documented anti-fraud policies that are monitored for compliance.

These policies clearly spell out what constitutes fraud and provides guidance on such issues as facilitation payments, commission fees, gifts and conflicts of interest. All of these are potential minefields in developing markets.

Still, 33% of Canadian companies and nearly 40% globally don’t have formal anti-fraud policies —a finding virtually unchanged from Ernst & Young’s 2003 global fraud survey. Not surprisingly, it is those companies (one in five) with a formal worldwide anti-fraud policy in place that have opted to forgo investing in an emerging market as a result of a thorough fraud risk assessment.

For anti-fraud policies to work, people must be held accountable to guidelines. And, above all, the policies must be communicated and supplemented with quality training and support mechanisms, such as whistleblower hotlines.

The survey reveals that 25% of companies that do communicate their policies to employees fail to provide proper training to ensure the policies are understood and implemented. And less than half with policies communicate them to suppliers and customers, while fewer still share them with agents, intermediaries and joint venture partners.

A marketing promotion or sales effort by a third-party affiliate in an emerging market, for example, could draw unfavourable attention from home country enforcement agencies, so it is critically important that compliance regimes stretch across supply and distribution networks. Businesses need to protect their operations at all the key points where they are exposed to fraud risk.

Financial statement fraud shouldn’t be underestimated
To some extent, the reliance on third parties in emerging market operations—where facilitation fees often change hands—could explain why respondents in developed market operations rank corruption and bribery well ahead of financial statement fraud as the types of fraud most likely to occur there.

Companies could be doing themselves a terrible disservice by underestimating the sophistication of fraudsters in developing nations by focusing primarily on corruption and bribery. Financial statement fraud is a far more serious crime, with greater consequences to a company’s bottom line and reputation.

SEC registrants are well aware of the SEC’s scrutiny of their international units’ compliance with U.S. GAAP; and for the rest of the world, International Financial Reporting Standards (IFRS) implementation remains an issue. Where the transition from local GAAP to IFRS might have a negative impact, local leaders could feel pressured to misinterpret or partially apply certain standards to bolster their historical results. Internal investigations may be slow to uncover problems, which could result in litigation and potentially significant costs that could be material to the parent company.

If anything, the Ernst & Young report underscores the need for companies to take their focus on internal controls over financial reporting and translate them into formal anti-fraud policies that are harmonized with local practices in emerging markets.

Fraud is complex and constantly evolving. Executives must go into new markets with eyes wide open, having done proper due diligence, including a thorough fraud risk assessment. If you have no formal framework in place, no communication, training or support mechanisms, you won’t be able to prevent or detect fraud. Companies must stay a step ahead of fraudsters by exercising strict vigilance every time, everywhere.

Mike Savage is a partner and Canadian leader for Ernst & Young’s Fraud Investigation and Dispute Services practice.

Bob Ferguson is a partner in Ernst & Young’s Fraud Investigation and Dispute Services practice in Toronto.

To view the Ernst & Young ninth global fraud report, visit www.ey.com/ca.