Weathering the tempest of corporate fraud

In the last year, industries across the board have experienced one of the most tumultuous markets in history. No industry, including oil and gas, has been immune from the economic downturn and potential pitfalls of fraud-related incidents. Today’s turbulent market has created the perfect storm for corporate fraud in the world of energy and other business sectors.

Data from the Energy Information Administration (EIA) shows a quick snapshot of the financial uncertainties faced by the oil and gas industry. For instance, the annual price of West Texas Intermediate (WTI) crude oil averaged $100 per barrel in 2008. The global economic slowdown is projected to cut these crude prices to an average of $42 per barrel in 2009 and $53 in 2010. The Henry Hub natural gas spot price is projected to decline from an average of $9.13 per thousand cubic feet (Mcf) in 2008 to about $4.70 per Mcf in 2009, but then increase in 2010 to an average of almost $5.90 per Mcf.

An Ernst & Young survey shows that fraud is alive and well. Between November 2007 and February 2008, Ernst & Young researchers conducted 1,186 telephone interviews with senior decision makers in large organizations. The sample was structured to include respondents from key parts of the company, including senior financial and risk managers, as well as the leaders of legal, compliance and internal audit groups. They conducted the interviews using local languages in 33 countries. Decision makers, including those from energy companies, reported the following:

• One in four respondents said its company had experienced an incident of bribery and corruption in the last two years.
• Twenty-three percent of the respondents knew that someone in their company had been solicited to pay a bribe to win or retain business.
• Eighteen percent of respondents said they knew their company had lost business to a competitor who had paid a bribe.

Understanding fraud and its costs

In order to avoid fraud and corruption, it is best to understand the definition. According to the Association of Certified Fraud Examiners (ACFE), fraud is “deception or misrepresentation that an individual or entity makes knowing that the misrepresentation could result in some unauthorized benefit to the individual or to the entity or some other party.” In other words, mistakes are not fraud.

Opportunity and pressure are two factors that are typically present during a fraudulent activity, according to Donald R. Cressey, a criminologist who studied embezzlers. Opportunity and pressure are directly tied to today’s corporate environments and can be influenced significantly by management. Opportunity can arise from lack of organizational controls and security; a company deficient in these areas is creating ample opportunity for fraud to occur. Pressure can be created by the demands to hit numbers that meet Wall Street expectations or that can increase compensation under management incentive plans.

Certainly, some organizations are feeling the pressure to hit their numbers as Wall Street fights to restore market optimism in 2009. Yet, companies should tread through this deep water with caution. Pressure can impact the “tone at the top,” or the implicit messages that management sends to employees by virtue of emphasis, proportion and frequency. A tone that places a disproportionate emphasis on financial results or stock price may send the message that cutting corners is acceptable, which clearly is not the case.

Asset misappropriation, corruption, and fraudulent financial statements are generally the three categories of fraud. Asset misappropriation, or stealing, accounted for 91.5% of corporate fraud in the cases studied in a 2006 ACFE Report to the Nation on Occupational Fraud and Abuse. Corruption accounted for 30.8% of the fraud cases, which can include conflicts of interest, bribery and extortion. Fraudulent financial statements, or fudging the numbers, were the least-frequent form of fraud.

Pay close attention to reporting hard assets, doing business remotely

Oil and gas development is one of the most capital-intensive endeavors in the world. It’s not uncommon for an energy industry project to require billions in capital spending.

Additionally, for many energy companies, success means winning in new and emerging markets.

Yet, companies should be cautious. Ernst & Young’s most recent annual Global Fraud Survey suggests that capital-intensive companies doing business in emerging markets, especially energy companies with numerous operating facilities abroad and within US borders, may be underestimating the risk of financial statement fraud.

Respondents to the survey considered bribery and corruption to be the greatest fraud risk in emerging markets. Ernst & Young’s experience demonstrates that lack of management oversight and controls at remote locations can cause significant financial statement errors in business units. This should be a clear signal that remote business units need aggressive oversight controls.

Companies making strides, but still a long way to go

Improvements have been made over the years in detecting and prosecuting people involved in fraudulent activities. Companies are recognizing the risks of fraud and doing more to implement anti-corruption policies and procedures into their compliance programs.

More than half of Ernst & Young’s respondents cited increased training and awareness in reducing the risks. Additionally, more than 45% of the respondents claim to conduct anti-corruption due diligence routinely prior to an acquisition. More than two-thirds of the respondents believed their internal audit teams had sufficient knowledge to detect bribery and corrupt practices, and half thought compliance-focused audits were successful in mitigating risks.

From 1999 to 2003, the number of SEC enforcement cases relating to financial statements and reporting alone more than doubled. The sweeping regulations of Sarbanes-Oxley, designed to help prevent and detect corporate fraud, have exposed fraudulent practices that would have gone undetected in the past and could have led to significant financial loss. Take, for example, the energy industry. In 2008, the median per-incident loss due to fraud in the oil and gas sector was $250,000, according to the Association of Certified Fraud Examiners’ 2008 Report to the Nation on Occupational Fraud and Abuse.

Companies need to be aware of fraudulent activities at home and, where there are commercial interests, abroad as well. Among the many laws for fighting corrupt practices abroad is the Foreign Corrupt Practices Act (FCPA) of the United States, which has become the de facto international standard regarding the bribery of foreign officials. Enforcement efforts by the Department of Justice (DoJ) and the Securities and Exchange Commission (SEC) are much more aggressive and extraterritorial than we are currently seeing elsewhere.

The FCPA is not relevant just to SEC registrants or US-headquartered companies. US citizens are not the only ones that have been subjected to its enforcement. For the DoJ, the fact that corrupt payments traveled through US clearing banks may be enough of a nexus with the US to bring charges.

For instance, an illicit payment from a European company to an Asian consultant that passes through a US clearing bank could provide jurisdiction for US enforcement. As a result, any company looking to acquire businesses or conduct commerce abroad is stepping into an increasingly active global regulatory flight against bribery and corruption.

Companies can benefit considerably from both increasing their knowledge and awareness of the FCPA and improving their capabilities to mitigate the risk of bribery and corruption. Interestingly, only one-third of Ernst & Young’s respondents claimed to have some level of knowledge about FCPA. Additionally, 58% of senior in-house counsel was not familiar with the FCPA.

Executives that were surveyed would appear to be well positioned to combat bribery and corruption. More than half were from finance, with chief financial officers making up almost a quarter of the survey, and another 15% were senior internal audit directors. The other senior executives who participated in the survey included chief executive officers; chief operating officers; heads of legal, compliance and strategy; as well as audit committee directors and other board members.

Mitigating fraud risks

A robust anti-corruption program should begin with a thorough assessment of the specific risks of bribery and corruption facing the company. These risks are derived from applicable laws and regulations governing the company’s conduct and other facts specific to the company’s operations, including industry sector, international locations and amount of business interaction with foreign government officials.

Additionally, every professional in a sales, marketing or procurement function should receive anti-corruption compliance training. These professionals should understand clearly what internal resources are available to guide them in the event they should be approached for a bribe or other illicit payment. The anti-corruption compliance program needs to be integrated into the company’s overall compliance regime. Companies that fail to address their compliance weaknesses continue to take unnecessary risks.

A robust compliance program is not simply about avoiding penalties, or even about avoiding internal problems. It is about balancing the need to improve the business while keeping the company and its executives out of trouble. The anti-corruption policy itself should address such issues as contracting with agent and consultants, commercial bribery, accuracy of financial reporting and audits of internal controls.

Companies can also employ an anti-corruption compliance certification program. Many companies have formal programs to certify and recertify senior employees regularly on anti-corruption compliance. Certifications will not stop the deliberate wrongdoer, but the requirement will serve as a continuing reminder of the manager’s compliance responsibility. Certification processes also may identify issues that otherwise might not surface.

No compliance program – no matter how expensive or extensive – can provide absolute assurance of compliance. Yet, isolated instances of corrupt conduct do not necessarily make the overall program ineffective. In the past, US regulators have shown certain leniency when the offending conduct was discovered by the company’s internal processes. Wrongdoers were dealt with accordingly, and remedial measures were undertaken quickly.

Management should take ownership when it comes to detecting fraudulent activities and should never be afraid to take action. The first step is to understand fraud. Then, when red flags surface within a company, management needs to ask the tough questions.

Schemes, red flags, and important questions

Whether it’s overstating revenues, understating expenses or improper asset valuations, companies should be aware of schemes and red flags. And management must ask the important questions and get critical answers. The following are areas to keep on your radar screen.

Schemes for overstating revenues

• Recording gross, rather than net, revenue
• Recording revenues of other companies when acting as a middleman
• Recording sales that never took place
• Recording future sales in the current period
• Recording sales of products that are out on consignment
• Schemes for understating expenses
• Reporting cost of sales as a non-operating expense so they do not negatively affect gross margin
• Capitalizing operating expenses
• Not recording expenses in the proper period, or not recording some expenses at all

Schemes for improper asset valuations

• Manipulating reserves
• Changing useful lives of assets
• Failing to take a write-down when needed
• Manipulating estimates of fair market value

Schemes for other common areas

• Smoothing of earnings
• Disclosing information improperly, especially concerning related-party transactions and loans to management
• Executing highly complex transactions, particularly those dealing with structured finance, special purpose entities and off-balance sheet structures

Red flags for overstating revenues

• Unusual increases in income or income in excess of industry peers
• Significant unexplained increases in fixed assets
• Recurring negative cash flows from operations while reporting earnings and earnings growth
• Allowances for sale returns, warranty claims, etc., that are shrinking in percentage terms or are otherwise out of line with those of industry peers
• Recurring negative cash flows from operations while reporting earnings and earnings growth
• Significant declines in customer demand and increasing business failures in either the industry or the overall economy
• Assets, liabilities, revenues or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate

Red flags for understating expenses

• Increased revenues without a corresponding increase in cash flow, especially over time
• Significant, unusual or highly complex transactions, particularly those that close near the end of a financial reporting period
• Unusual growth in the number of days’ sales in receivables
• Strong revenue growth when peer companies are experiencing weak sales

Red flags for other common areas

• Domineering management
• Decision to fix accounting in the next period
• No apparent business purpose
• “Reality” of transaction differs from accounting or tax result
• Significant related-party transactions
• Counterparties that lack economic substance
• Multiple memos rationalizing an aggressive accounting treatment

Questions to ask if you suspect overstating revenues

• Why did revenues increase sharply during the end of the period compared with prior-year and current-year results and the budget forecast?
• How does revenue growth compare with that of peers during the same period? If substantially higher, does the explanation make sense?
• Did receivables increase due to a particular customer? If so, should a reserve be established?

Questions to ask if you suspect understating expenses

• Why did gross margin (by location, product and geographic area) increase during year-end or period end compared with the prior-year and current-year budget forecast? Does the explanation make sense?
• How does the company compare to competitors in terms of net income during the same time period?
• What were the major additions to fixed assets during the year? Is the treatment of recording assets consistent with that of prior years?

Questions to ask if you suspect improper asset valuations

• How is the overall economy affecting customer demand and business?
• For areas where there are significant estimates, what is the method used to determine the estimate? Is this method consistent with that of prior periods? What supporting documentation is available to support the calculation?

Questions in other common areas

• Is there an overly aggressive push by management to meet previously disclosed revenues or earnings targets?
• Can management explain the business purpose for entities that are outside the consolidated financial statements?
• Were there significant adjustments made at the end of the period?

Trust your judgment

Managers should always trust their judgment and intelligence when considering accounting red flags. Sometimes these red flags will have legitimate explanations, but other times they may be only a small part of financial statement fraud.

About the authors