Classification of corporate fraud

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P od corporate fraud practitioners understand different ways of appropriation of assets and manipulating statements in order to mislead investors. Corporate fraud worsens the business environment, leads to the ruin of entrepreneurs, and leads to a decrease in tax revenues to the state budget. The fight against it should be based on a scientific apparatus based on foreign and domestic practice of law enforcement.

Theory of Combating Corporate Fraud

In the theory of the classification of corporate fraud and the fight against it, the main works are considered to be the works of such researchers as K. Schipper, K. Marchand, J. T. Wells, J. M. Zach, J. L. Kovasich. Their work is based on almost two hundred years of practice of combating illegal creation of joint-stock companies, “soap bubbles”, and distortion of reporting. Russian corporate governance standards are much younger, therefore, the scientific classification of types of corporate fraud is complicated from both practical and theoretical points of view.

The Ministry of Finance of the Russian Federation has developed recommendations for the implementation of a legitimate risk assessment of all abuses associated with the acquisition of new assets, maintaining accounting records, performing certain actions that may be caused by commercial bribery. The classification of the Ministry of Finance of the Russian Federation largely coincides with the classification proposed by the Associated of Certified Fraud Examiners (ACFE). Both the regulator and the international research organization distinguish three types of fraud:

  • corporate corruption;
  • fraudulent reporting activities;
  • misappropriation of assets.

The harm of corporate fraud to the company and society is manifested in various types of damage , financial and non-financial:

  • damage caused to the company's business reputation, which often negatively affects the capitalization of its shares;
  • a decrease in product quality due to a hidden reduction in the cost of components and the quality of work as a result of the appropriation of part of the funds allocated for the formation of costs;
  • deterioration and loss of business ties with partners who prefer to refuse to work with a company whose business reputation has decreased as a result of revealing the facts of corporate fraud;
  • significant decrease in the efficiency and profitability of activities;
  • a decrease in the growth rate of the entire business and its individual areas;
  • decline in competitiveness;
  • deterioration of relations in the team, creating an atmosphere of suspicion;
  • deterioration of creditworthiness and attractiveness for investors;
  • direct loss of assets.

All these negative phenomena arise due to the extremely low quality of corporate governance in Russian companies, the absence of working codes of corporate ethics, and internal control systems. In most cases in Russia, crimes that can be characterized as corporate fraud are committed by executive personnel and top management. Abroad, this kind of offense is committed by middle and lower-level personnel. Counteraction to corporate fraud committed by the top management of private companies is often possible only on the part of minority shareholders, who often involve law enforcement agencies to identify such facts or use judicial mechanisms of corporate control.

Researchers of the Russian practice of fraudulent activities note that the most developed crime in our country is the misappropriation of assets, which can be expressed in the form of theft, embezzlement, and embezzlement. It accounts for more than 70% of all criminal manifestations. Less common and less detectable are reporting fraud, both in financial and accounting documents of individual legal entities, and in consolidated documents of a group of persons, within which corporate fraud and asset stripping often occur. Thus, the transfer of assets within a group of persons may not be recognized as an interested-party transaction or a major transaction, but it is precisely such transfers of assets or the understatement of their value that make it possible to deprive minority shareholders of their share of the profit from the company's activities.

Top Causes of Corporate Fraud

If we talk about the reasons for this type of fraudulent activity, then we can distinguish three main groups:

  • agency conflict between the owner and top management;
  • the desire of the majority shareholder to deprive their minority shares of profits;
  • misleading banks and investors by distorting financial statements and wasting funds in order to misappropriate loans and investments.

Agency conflict as one of the main causes of corporate fraud often arises as a consequence of the failure of shareholders to fulfill their obligations to motivate the manager's activities. Feelings of offended pride lead to asset stripping and profit hiding. The second interesting reason for the agency conflict is the low quality of corporate management of the blocks of shares owned by the Federal Property Management Agency. At such enterprises, corporate control is often absent altogether, which leads to numerous controlled bankruptcies, appropriation of assets, and other fraudulent activities.

The task of regular management, designed to completely eliminate agency conflict and corporate fraud as a result, is solved with the involvement of significant resources.

Ways to eliminate agency conflict

When building a corporate control system, shareholders should consider it in several dimensions at once.

Changes in the provisions of the charters, regulations on Boards of Directors, and other corporate documents, which sharply reduce the powers of top management, should become one of the main practices for preventing corporate fraud. The law provides a wide range of opportunities for such adjustment of documents, and it cannot be neglected. The changes will help to stop the registration of a real estate transaction, and to recover damages from the head or his deputy, caused to the company by his illegal actions, fraud, deception or breach of trust.

The second way to deal with agency conflict will be the wide use of external audit capabilities. Despite the fact that audit companies are chosen by meetings of shareholders or participants, they very often become conductors of the interests of management, deliberately carrying out checks in order not to see distortion in the reporting. Timely change of such companies and setting them separate terms of reference with an emphasis on possible shadow and risk zones will help strengthen control over the activities of managers.

Corporate ways

Corporate controls also include the creation of services such as:

  • economic security service;
  • internal audit service;
  • KRU (control and audit department).

While these units are aimed at detecting corporate fraud, they are often ineffective, especially when the violation is initiated by the controlling shareholder. They can become an effective tool for identifying violations by employees, but in most cases they will not interfere with the activities of top management and shareholders. The solution to the problem will be subordination of the internal control services to those committees of the Board of Directors in which independent directors are present.

The board of directors, if it is a working body and includes independent directors, will help both minimize the risks of agency conflict and reduce the influence of controlling shareholders. It must include independent directors who are not associated with any of the shareholders, and its activities must be carried out on an ongoing basis. The council must agree on all relevant documents - from the procurement plan to the investment policy.

As part of the Council, it is necessary to create committees that will help resolve emerging conflicts:

  • the remuneration committee will reduce the problem of unpaid bonuses and internal conflicts;
  • the audit committee will ensure that truly independent reviews of the company are carried out.

The costs of organizing the work of the Board of Directors formed in this way can be high, but they are always justified. Also, we must not forget that a number of important powers are given by law to such a body as the Audit Commission.

Staff motivation

Any stakeholder in relation to the system, in this case to the corporation, aims at a fair and equilibrium ratio of the forces given and the profit received from this. If a top manager sees that his activities bring the company a significantly greater inflow of income than his motivation, it is expected to decrease, which in the absence of well-functioning corporate procedures can lead to facts of corporate fraud. Therefore, the company should have an objective system of motivation that clearly evaluates labor input and remuneration for it, but, on the other hand, implies prompt and inevitable punishment for any action that damages the company. At the same time, disciplinary measures are not enough. If the audit or the audit committee has identified signs of fraud, the involvement of law enforcement agencies is necessary.

In addition to external auditors, software products will help to identify such cases, allowing to determine the facts of collusion, malicious theft of information, violation of the commercial secret regime. Among such products, it is recommended to use modern programs that make it possible to protect the company's information perimeter from unauthorized actions by stakeholders, leaks, unauthorized copying or data transmission. These tools include DLP systems and SIEM systems. The former are configured in such a way as to completely exclude information theft by internal users, while the latter detect and identify various information security incidents, allowing full risk management and protection against intrusions through the external security perimeter.

Economic and information security services are responsible for their implementation, and their remuneration should depend on their ability to detect and prevent corporate fraud.

Fight against manipulation of reporting

This type of corporate offense is often used by both controlling shareholders and middle managers, whose interests are to overestimate the indicators: sales, revenues, net income and capitalization of the company's shares.

Such distorted reporting is not always immediately detected, including by the tax authorities, but usually causes significant damage to the company and its minority shareholders. It should be understood that distortions are most easily introduced not in the financial statements, the rules for the preparation of which are strictly regulated by Russian accounting standards, but in the IFRS statements, which are provided to banks and investors. The obligation to draw up such reports is assigned by law to large joint stock companies; banks; insurance companies and a number of some other market participants.

But very often, in order to obtain an investment or a loan, the borrower is offered to prepare and submit reports prepared according to these standards. And here a problem arises due to the fact that IFRS involves the use of concepts such as fair value and the priority of economic content over form. The problem appears due to the lack of clear assessment criteria, its various methods and ranges are possible, this logically leads to the fact that subjective distortions are introduced into the reporting. With premeditated intent and wide margin of distortion, they take the form of corporate fraud.

Corporate Fraud Methods

Thus, in the study of the causes, subjects and types of committing offenses, one can clearly build the following classification:

  • fraudulent actions with assets, which include their illegal sale as a result of uncoordinated transactions, write-off of assets from the company's balance sheet, estimated undervaluation of assets, replacement of valuable assets with less valuable ones;
  • withdrawal of proceeds to companies specially created for these purposes, subsidiaries, associates or so-called "technical" ones, in foreign practice they are called special purpose entities. This entails a decrease in revenue, an unjustified increase in expenses, a decrease in profits, and the occurrence of losses. This type of fraud is used most often in order to reduce the income of minority shareholders, and its key example in Russia was the Yukos case;
  • burdening the company with obligations. This leads not only to their growth, the ultimate goal of such actions often becomes controlled bankruptcy with further withdrawal of assets;
  • accounting fraud leads to a change in the true value of assets, the amount of liabilities, both receivables and payables.

Risk factors

When analyzing the work of a company in order to identify possible risks of corporate fraud, researchers recognize the following types:

  • a low level of control over the activities of company executives by top management, which is unable to identify the risk of fraud. The scope of authority of leaders is not limited by anything, it is not balanced by their limitations and control;
  • management motivation based on increasing the company's capitalization. It is she who leads to the majority of violations associated with misstatements of financial statements;
  • a large proportion of transactions with related and affiliated companies. This unambiguously speaks of manipulations with the size of expenses and revenues, as well as the transfer of losses to subsidiaries, which leads to an overestimation of the financial indicators of the parent;
  • frequent change of suppliers and buyers. This testifies not only to the lack of stable positioning in the market, but also to the fact that the company uses technical firms specially created for this purpose and quickly liquidated to increase costs and reduce income;
  • a complex business structure in which operating companies operate separately from asset holders, trading houses, outsourcing and consulting firms are additionally created. This will clearly indicate the risks of tax and revenue manipulation.

An experienced expert conducting a business audit will be able to identify most of the risk areas by making his own classification of the methods of corporate fraud used. Based on this data, the investor or banker will be able to make an informed decision about the possibility of lending to such a business.