Corporate fraud: The veil of silence

By Dr. Michael-A. Leuthner, CPA

Most people don’t like negative news, therefore people tend to simply sweep the problems under the carpet, and after all they do not wear their hearts on their sleeves. Nobody is interested to peddle on the subject. But see what’s coming next.

Interestingly, after the second article was posted in Germany at www.xing.com, in the first 24 hours it received over 4,500 hits. One reason therefore was also the upcoming of ‘Dieselgate’ with Volkswagen AG. So, there could be the impression that reporting about fraud seems again ‘en vogue’.

This could lead us to the conclusion that neither the company that discovered a fraud is motivated to publish bad news, nor suppliers, customers shall be informed about that incident. Furthermore, creditors shouldn’t be informed after all. Why is that so?

 

Fraud Part IV: The veil of silence

Following the first article of this series, which described the human factor in fraud, the second article described the different kinds of fraud that can be found in a business context. In the third article it was explained how to deal with a freshly discovered fraud in an organization and what specific steps should be taken next. The fourth article showed which simple but highly effective measures can be taken to deter occupational fraud.

This fifth article describes the reasons for the reduced motivation of a company to inform customers, creditors and shareholders that fraud was discovered within the company. But a concealment of fraud against the stakeholders could have negative consequences.

The company that uncovered the fraud is afraid that their relationships to customers and suppliers are going south and the reporting requirements to their creditors will increase because of lost trust. But that’s not all, they fear that their external auditor is auditing the next time more accurate. The company wishes to avoid this alleged time and effort. Why is that so?

But maybe

• The increased reporting requirements are an adequate procedure to reduce and prevent fraud in the future?
• Trustfully relationships to suppliers and customers are adequate means to reduce and prevent fraud in the future?
• Rendered information to the external auditor him for his risk-based audit approach and can be an advantage to discover new information for supporting his client in identifying weaknesses?

 

Just before analyzing the whole picture, it should be useful to take a snapshot on the range of interests of the different parties involved:

Interest situation of customers:

Essentially it is very simple and not oversimplified; customers would like to have a ‘candid’ high-quality product and not a cheap one, instead they want a well-priced product.

Interest situation of suppliers:

The supplier demands for the delivered goods and services a trustworthy and in time paid amount according to the negotiated contract.

Interest situation of creditors:

First of all, creditors are interested in a trustworthy and in time paid debt service. For decreasing their own risk, they demand regular financial reports, for being sure that the company will be able to pay the debt service in the future.

Interest situation of board of management:

Alongside a successful management of the company, the managers have in most cases the interest of reducing their individual risk to a minimum.

As part of the overall audit procedure a letter of representation is rendered from management to the auditor and contains amongst other things:

• Management’s acknowledgment of its responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles.
• Management’s acknowledgment of its responsibility for the design and implementation of programs and controls to prevent and detect fraud.
• Knowledge of fraud or suspected fraud affecting the entity involving (1) management, (2) employees who have significant roles in internal control, or (3) others where the fraud could have a material effect on the financial statements.
• Knowledge of any allegations of fraud or suspected fraud affecting the entity received in communications from employees, former employees, analysts, regulators, short sellers, or others[1].

 

Sometimes it seems that the board of management is not aware what documentation hereby is signed by them.

 

Interest situation of shareholders/owners:

As a rule, profit maximization goes along with minimization of risk in the mind of the shareholders and owners. The present economic situation is especially risky because shareholders suffer because the press likes it to print something about fraud incidents.

Interest situation of supervisory board/advisory committee:

The behavior of the supervisory board is probably the same, they are not only reflecting the interests of the shareholders and the owners, furthermore also the interests of the employees[2]. Nevertheless, one of their main interests is reducing their individual risk to a minimum.

Interest situation ot the external auditor:

Simply said, an audit[3] is the examination of the financial report of an organization according to the laws and regulations of that specific country. Due to constraints, an audit seeks to provide only reasonable assurance that the statements are free from material error. Which means the auditor is also trying to reduce his individual risk to a minimum.

After having discussed the interest situations of all involved parties it is not difficult to recognize that everyone besides profit maximization, there is the common goal of risk minimization.

What has to be done?

You should be aware of the fact that you can never ever avoid fraud to 100%. If this would be your intent, the number of monitoring employees would then probably be higher than the number of working employees. In the worst case, you will be successful in curtailing fraud, in the best case, and on that you should concentrate your efforts, fraud can be reduced to a vanishing, although (probably never) acceptable amount.

The press gloats over non-existing compliance as a reason for so many fraud incidents in companies. But what means compliance, what is that in its basics?

According to Merriam-Webster Compliance is „the act or process of doing what you have been asked or ordered to do: the act or process of complying. [4]”

In general, compliance means conforming or compliancy with laws and regulations, such as a specification, policy, or a standard. Regulatory compliance describes the goal that organizations are aware of and take steps to comply with relevant laws and regulations.

Back to the life:

The most and valuable steps, according to the opinion of the author, is gaining a common understanding of the whole value-added chain of the company. This is true not only for inside the company, but also to its outside partners and parties. Not only fulfilling candid supplier audits from both sides, further more a common understanding should be created, this is also valid for huge companies, until the last part of the chain, the consumer.

Opportunities arise not just through a proactive „uncovering“ of vulnerabilities or even of fraud, it can restore and strengthen trust with suppliers and customers.

Who is responsible for the entire topic of compliance? Is compliance just a new hype or it implies actually something? Are current events, only the tip of the iceberg?

The Board of directors or the Managing Director is responsible for the compliance with laws and regulations. They have to take care, that these rules are respected. Since they can’t all do the tasks by themselves, these tasks must be delegated and monitored.

At the beginning of all efforts, however, the training of the own employees is one of the most important tasks.

Again, it’s estimated that the typical organization loses about 5% of revenues in a given year as a result of fraud. Training of your own employees always pays off.

Stay tuned!

Dr. Michael-A. Leuthner is a:

Certified Public Accountant

Certified Fraud Examiner

Certified Internal Auditor

Certified Financial Services Auditor.

 

Email: leuthner@cpa-leuthner.com

[1] AU Section 333, Management Representations, https://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00333.pdf

[2] depending on the regulations of the different countries

[3] Within this article we are speaking of a financial statement audit

[4] http://www.merriam-webster.com/dictionary/compliance

 

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