Fraud in foreign operations: is fraud lurking in your organization's foreign subsidiaries? Ten warning signs can help auditors determine what to look for and where the risks may lie

Internal Auditor, August, 2002 by Allen J. Genaldi

THE NEED FOR MULTINATIONAL CORPORATIONS TO monitor, prevent, and detect suspicious activities is perhaps greater now than ever before. The proliferation and widening scale of financial-statement fraud, as well as increasing corruption in organizations worldwide, demands the attention of all firms, but especially those that extend their operations beyond national borders. Multinationals are particularly vulnerable to fraudulent activity, as opportunities for abuse can increase when subsidiaries are maintained abroad. * By aggressively seeking and investigating warning signs of fraud, multinational firms can substantially minimize the risk of abuse. Internal auditors, as the "eyes and ears of management," are particularly well-suited for this task. Because auditors are uniquely positioned to observe and respond to suspicious activity, their efforts can be invaluable to organizations seeking to reduce exposures in outside subsidiaries.

During recent forensic accounting engagements, the Dispute and Analysis Investigations Practice at PricewaterhouseCoopers uncovered several incidents of fraud at some of its multinational clients. Based on these investigations, we have identified to red flags that could indicate vulnerability to infiltration and abuse. These warning signs, and examples of them drawn from our experiences, may be helpful to internal auditors charged with preventing and detecting fraud in foreign operations.

(1) PRESSURE TO COMPLETE A MERGER OR ACQUISITION

Confusion often becomes the norm during, and for some time after, merger and acquisition (M&A) transactions. As momentum accumulates, many transactions become "deals of destiny," and individuals normally responsible for safeguarding assets, monitoring compliance, and maintaining control at the acquired company can easily become distracted by the pressure of closing the deal. On the purchaser's side, due diligence efforts may involve nothing more than completing minimal requirements to gain comfort that financial statements are accurate. Furthermore, when most efforts are focused on moving the transaction forward, companies do not tend to look kindly on the skeptic who kills the deal.

Foreign transactions can lead to even more confusion. Language barriers, time differences, and cultural idiosyncrasies may complicate M&A deals, as well as facilitate opportunism. It is not uncommon, for example, for foreign management to secure a "soft landing" during the turmoil of an M&A transaction by colluding with vendors, misusing company assets for personal gain, or setting up a conflicting business and directing clients away from the company.

A group of European executives created such an opportunity shortly after a U.S. company acquired their facility. The executives informed their U.S. parent that certain business deals were not pursued because they didn't fit company strategy, but in reality they were holding meetings with the potential business partners in the name of a different company they controlled. At another multinational firm, managers decided to boost their portfolios with company stock during a global acquisition, using "employee loans" to raise the capital. In both these instances, management's shift in focus from day-to-day operations and controls to meeting performance targets, responding to due diligence, and anticipating post-acquisition changes comprised the organization's ability to prevent illicit activity.

(2) COST-SAVING STRATEGIES

Although budget cuts, strategic restructuring, and staff reductions are common occurrences in large organizations, such decisions often foster ill will among the affected workforce. The potential for misunderstanding increases when these decisions take place across national borders. Workers at foreign subsidiaries may assume that their country's workforce has been deemed a lesser priority and that the firm's executives have callously resolved to eliminate jobs in favor of higher profits. This perception can create pressure on foreign managements that struggle to balance their loyalty to the company and to the people with whom they work on a day-to-day basis.

In a Brazilian subsidiary of a large U.S. multinational, managers decided to take care of their own people in the face of a mandated workforce reduction by creating a fictitious vendor to employ terminated workers. The employees continued to work at the company every day and were instructed to stay home on days the auditors would be visiting, while the company continued to pay these individuals through inflated disbursements to the vendor. U.S. management's cost-saving strategies, therefore, were effectively negated by the subsidiary's actions. The entire scheme might have actually worked had declining profitability not necessitated investigation and intervention.

(3) INEXPERIENCE IN INTERNATIONAL MARKETS

The growth appeal of international markets often encourages companies to steam ahead before learning to read the charts.

This especially holds true in the high-growth technology world, where many firms blossom under highly talented but often inexperienced entrepreneurs.