Prevention of Architected Financial Frauds

Dr. D. Mukhopadhyay
Commitment of financial frauds in India has become a common phenomenon during last decade and hardly there is any reported exemplary punishment, for the fraudsters so far, that has been administered by any government in our country. In recent past as far as our memory goes, after, Harshad Mehta, Ketan Parekh scams, Sahara India, Liquor baron, PNB , Satyam and many more in the list may get rooms but so far hardly anything has been recovered from them to the public coffer. It is very difficult to say the exact point of time when the first financial fraud was committed except a reference can be had to the Greek history when Mr. Hegestratos, a Greek merchant, was reported to have committed a financial fraud in 300 B.C. Mr. Hegestratos took a remarkably large insurance policy known to have been ‘Bottomry’. This merchant had a boat and he used to borrow money and agrees to pay the same back with interest when the cargo named to be the corn in this case is delivered. In case the borrower defaults in repaying such loan, the lender could acquire the boat including the cargo. Under the circumstances, Mr. Hegestratos had planned to sink his empty boat, keep the loan and sell the corn. However, unfortunately it did not work as it was planned and the drowned was trying to escape his crew and passengers when he was caught in the act. This is the first reported fraud in the history of Commerce. It has been observed that members of different professional Institutes and professional associations are found to be the chief architects of such financial frauds which is very a disappointing to note. Financial frauds becomes an inevitable practice which has positive correlation with economic growth. Indian economy is a promising and growing economy in the eyes of the experts and researchers in the fields of Commerce, Management and Economics. Commitment of frauds is the resultant output of cultivation of greed by the people equipped with professional qualifications in most of the cases as it appears from prima facie investigation and enquiries made by the administration. Initially the fraudsters use the underlying loopholes of the concerned laws of the land in order to architect the route though which financial assets are swindled.
Frauds are by and large grouped into the categories of financial or accounting frauds, misappropriation of financial assets known as frauds committed by the corporate insiders and finally obstructive conduct frauds. The first group of frauds i.e. financial frauds comprise of falsifying financial information by fudging the books of accounts in order to mislead the investors and others who are related to the commercial operation of the organizations. The most mentionable frauds under this group include adopting accounting methodology for capitalizing revenue expenses , swap transactions, side deals, channel stuffing, accelerated revenues and deferred revenues as well. This kind of frauds are committed by the management with the help of the auditors of the companies. The auditors can easily detect this kind of frauds if they discharge their duties with professional integrity. The second category of frauds i.e. self-dealing by corporate insiders mostly associated with misappropriation of company assets by the senior executives. There is a common practice of the companies to grant loans to senior management of the company and these are hardly repaid and no material disclosure is made in the annual reports of the organization, sometimes, company reimburse the personal expenses in the process of wrong treatment of such expenses as if they are incurred for organization promotional purposes. Besides frauds known to be insider frauds, use of organizational property for personal purposes, kickbacks and individual tax avoidance and violations of the provisions of the Income Tax Act , 1961 and Income Tax Rules, 1962 and many other allied laws of the land. Finally, frauds relating to obstructive conduct consists of falsifying testimony to the regulations, evaporating the records and files from the computers and information system and altering and shredding important documentary evidences which could be used in detecting frauds in the organizations. Whatever kinds of frauds are mentioned here, directly or indirectly they are associated with financial implications and it is the auditor who is professionally equipped to detect such financial irregualties and professionally obliged to strongly qualify the reports whenever they came across such frauds. In Sataym Computer Services Ltd. case, it was found that auditors did not apply their professional skill and competence to do justice to the duties they were meant to perform.
It may be worth mentioning that this is the high time for the regulators and government to think out of box and search for substitute of such professionals because this kind frauds happened in India over again and again repeatedly which in essence proves professional incompetence of them otherwise. Financial frauds tell upon the financial health of many organizations in the world and India is one of them. Let us have tour to the fraudsters across the globe for a moment. Year of 2001 is the witness of Enron fiasco when shareholders lost about $74 bn, employees and investors lost their retirement benefits and many employees became jobless. Huge debt was kept off balance sheet. In 2002 , WorldCom financial scam was found to be involved with reporting of inflated assets to the tune of $11 bn which consequently made 30,000 employees lose their jobs and caused a loss to the investors to the tune of $180 bn. Let us come to case of Bernie Madoff(2008), when the investors were paid returns out of their own money or that of other investors rather than from profit and it was one of the largest ponzi scheme. Again in the same year, Lehman Brothers committed a financial fraud to the tune of more than $50 bn. This is a very interesting case of financial fraud. The fraudster sold toxic assets to Cayman Island Banks with an understanding that they would be bought back in due course and it created a hype that Lehman Brothers had $50 bn more liquid cash in the coffer and $50 bn less in toxic assets than it really had . Saytam case already mentioned above. It falsified revenues, margins and cash balance to the tune of $1.5 bn and cheated the stakeholders of the company.
Olympus financial fraud was committed in 2011 to the tune of $1.7 bn. Herein Olympus created a Tobashi scheme in order to shift losses off the balance sheet. Companies located in the Cayman Islands were bought with exorbitant merger and acquisition fees.
Toshiba financial scam was transpired in 2014 where profits were overstated by an amount exceeding $1 bn. Toshiba understated its costs on the long-term projects. The CEO of Toshiba had mounted tremendous pressure on the subordinate managers for achieving the sales targets and consequently, it pushed forward sales in accounting. The most glaring and recent financial scam committed by Nirav Modi in PNB case in India. If someone deeply ponders over the issues relating to the financial irregularities as well as financial scams as mentioned above, the financial auditors’ negligence and professional incompetence were by and large scanned by the investigating agencies. In a famous London General Bank Case(1895), it was held that the “Auditors are Watch Dogs and not Blood Hounds” and even if the true spirit of this case law decision is honoured today as delivered by Lord Lindley in London in 1895, it is clear to state that the Auditors failed to play the role of watch dogs even. India is the worst victim of financial frauds that happened over again and again and it caused a severe injury to national economy. During last several years, Indian market has been offering eye-catching opportunities to multinational enterprises for parking their investments in India and local companies are also getting opportunities for the scope of expansion overseas. The multinational enterprises take the route of joint venture, acquisition or establishing Greenfield presence in India and as result they experience commercial growth in their business but they are afraid of criticality in survival of their business operations .
According to the Association of Certified Fraud Examiners’ ‘Report to the Nations 2016′, India occupies the second position in terms of victim organizations reporting the cases. It is the time to redefine the role of the auditors and corporate governors who professionally responsible to detect and prevent financial and or other frauds in order to protect the financial interests of all the stakeholders associated with operations of the business of a firm. Irrespective of the size of the organizations, occurrence of frauds in corporate India is a regular feature and small frauds remain behind the curtain since they are hardly reported. Financial frauds stand for deliberate misrepresentation, misstatement or omission of financial information with an aim to mislead the users of financial information in order to give a rosy picture of the financial health of an organization which is not in real sense. The financial statement frauds are rampant practice which include improper treatment of revenue and expenses, manipulations of assets and liabilities accounting, non-disclosure or inadequate disclosure etc. Moreover, procurement frauds helps in siphoning off funds and window dressing the financial statements. During recent past, a huge number of shell companies in terms of lakhs have been deregistered by the Ministry of Corporate Affairs since these companies facilitate fraudulent payments and avoid tax payments. In view of the above, ultimate responsibility for fraud detection and prevention thereof comes on the shoulder of the regulators. The Companies Act, 2013 has provisions for addressing the risks arising out of frauds, assigning greater responsibility and increasing greater accountability for the independent directors and the auditors. The referred Act has also prescribed penalties for the key managerial personnel, auditors, employees and directors as well. The Companies Act, 2013 has also introduced a new phrase’ Internal Financial Control(IFC)” which contains the features of internal control (IC) and Internal Control for Financial Reporting (ICFR). The steps taken by government of India are definitely supposed to act as deterrent against the fraudsters but it is not adequate. The government should think out of box and not traditionally because nature and characteristics of frauds are occurring keeping pace with changing pattern of advancement of technology. The government is recommended to design a comprehensive anti-fraud framework in order to minimize the risk arising out of frauds and misconduct of the professionals entrusted for audit as well the employees who facilitate in defrauding activities in the organizations. As far as employees are concerned, it is necessary to develop an ethics code keeping in view the size of the firm and employee-mix . These ethics code should be appropriately documented and communicated to all the stakeholders. This document should contain the provision for disciplinary action for the employees found to be involved in fraudulent activities and it has continuously to exercise surveillance over the employees so that fraud can be prevented well in advance . In India, most of the time government frames control mechanism after breakdown of the system but not for prevention of the unwanted acts and omissions. The present era is the age of constant change and the business are to be well equipped for fraud risk assessment, ascertainment and uninterrupted monitoring as well in order gain the confidence of the investors and others who are directly or indirectly associated with present and future of the business.
(The author is Professor of Management, School of Business, Faculty of Management, Shri Mata Vaishno Devi University, Katra-182320, Jammu & Kashmir)