CFO Lessons From the War on Corporate Fraud

by Pearl Liu, 23 July 2012
“Never ignore anonymous letters, but do not take them at face value,” counsels Barry Tong, a partner in advisory services at prominent accounting firm Grant Thornton. Another piece of advice: “If it looks too perfect, chances are it is not true.” Also: Copies of bank statements, even those from world’s biggest financial institutions, can be faked.
 
These are some of Tong’s takeaways from more than 60 due diligence and transactions advisory engagements he has completed in Hong Kong and China in the past four years. “Taking cash from the till is not the story today,” he says. “With the rapid development of information systems, there is more transparency into employee behaviour.”
 
But that does not mean corporate fraud and misgovernance no longer exist. They are still with us, as they always have been – and likely to continue to do so, human nature and the pressures of doing business in volatile economic times being what they are.
 
Headline News
Indeed, CEOs, CFOs, financial controllers, accountants,  even external auditors have recently been making newspaper headlines, and not for the right reasons. For example, the Ontario Securities Commission recently sued for fraud Allen Chan, the former CEO of Chinese timber company Sino-Forest along with ex-CFO David Horsley and three other finance people.
 
When Hong Kong’s Securities and Futures Commission launched a fraud investigation of Shanghai Pharmaceuticals, its chairman, Lu Mingfang, was dismissed in April. 
 
Hontex International Holdings, a mainland Chinese textile and clothing maker, was found to have faked more than US$1 billion revenue before its  IPO in Hong Kong in 2009. Mega Capital, Hontex’s listing sponsor and sole book runner, was stripped of its license. In June, Hontex agreed to buy back more than HK$1 billion worth of shares from minority shareholders in a landmark settlement with its Hong Kong regulator.
 
The latest scandal involves Hong Kong’s premier property company, the blue chip Sun Hung Kai Properties, whose two joint-chairmen and co-managing directors, brothers Thomas and Raymond Kwok, were charged in July with bribing the city’s former No. 2 civil servant, Rafael Hui. The case has been adjourned until October.
 
Anonymous Letters
In Hong Kong and China, the most common offense is the solicitation of commissions by company staff in exchange for favourable treatment. ”The sins are usually difficult to detect until they have been exposed by anonymous letters,” says Tong. That’s why CFOs should take each one seriously. What the CFO should do is take note of the accusation and try to prove (or disprove) it.
 
It does not matter who the letter-writer is. In Tong’s experience, he or she (or they, in a group letter) can be “accountants finding some telltale signs of fraud from money transactions, suppliers who failed to win the bid, or even someone inside the purchasing team who did not benefit as much as the others on the fraud.”
 
“Going through the report word by word and looking for details is the very first thing you should do,” he advises. “You may find gold inside.” By gold, he means detailed descriptions such as the exact time of the transfers of commission fee, a list of specific suppliers that bribe employees and the exact amounts involved.
Though almost 100% of these letters will not contain the sender’s name, some may leave a contact number or email address. “Take note of every clue and contact the person to get more useful information from them,” Tong suggests.
 
With details and sources in hand, the CFO already has a rough picture about the case, and it’s time to arrange a talk with the subject of the letter and those employees around him or her. “It would be much better if the meeting is conducted in the course of a regularly scheduled company activity, like an internal review, because a sudden face-to-face talk is always quite sensitive,” says Tong.
 
When the Boss Cheats
What if it’s your superiors that you suspects are doing something illegal? “Look into it and remain suspicious even if he is the one who hired you,” Barry counsels.
 
Once, the CFO of a Hong Kong-listed mainland Chinese company, for which Tong was engaged to do an investment review, nervously confided in Tong.
 
Shortly after joining the company, the CFO noticed up to ten transactions every day that poured RMB1 million into a particular bank account. At the same time, there were up to 20 transactions that then funnelled some RMB20 million out of it. The company president, who has oversight over the accounts, could not give a satisfactory explanation.
 
“The CFO got more worried when he discovered that a customer was a former supplier,” Tong recalls. “He began to suspect that this customer is a special third party who has some relationship with the company president.” The CFO quit soon after he reported his findings to the board.
 
“Reporting is important, either internally to the board or externally [to the Independent Commission Against Corruption],” says Tong. “Do not think that because you left before the bomb exploded, you would be out of it.”
 
“The authorities will not let you go just because you are titled as the ‘former’ CFO,” Tong warns. “Criminal charges are possible if you did not report on time.”
 
Due Diligence
The case highlights the need for CFOs, particularly those that have just joined a company, to be sensitive to inconsistencies in the financial statements, suspect supporting documents and unusual changes in sales and profits.
 
Hontex, for example, reported what, in hindsight, seemed to be a too-good-to-be true sales increases – a 42.7% surge in revenues to RMB932.5 million in 2007 and another 37.8% rise to RMB1.3 billion in 2008. For the first half of 2009, the company claimed that sales jumped 56.6%.
Documents such as bank statements, which are sometimes accepted at face value, deserve more attention. “Even if it is from a big bank like HSBC, you should look at it carefully,” Tong says. “Your accountant in Guangzhou may just stick a real bank statement’s head on the one he faked and fax it to you.”
 
Due diligence should start even before you have joined the company, he advises. “The interview is not only about salary. You should get to know your employer and the expectations of the CEO or the president regarding your role.”
 
Some surprising things can surface during job interviews. A friend of Tong was once asked by the company president interviewing him how the accounts could be window-dressed to help facilitate the IPO process. “If you just keep saying yes, you may get the job, but trouble will come afterwards,” says Tong.
 
If you’re already aboard, he recommends spending time to get to know the finance team. “If the company has a branch somewhere in Heilongjiang Province, as CFO, you should fly there to meet them and let them know you,” says Tong. “Getting familiar with the company is compulsory for every newcomer.”
 
China Syndrome
This is especially important if you work for a company in China, where the company chop is more powerful than a signature. The accountant may stamp the accounts by himself and file them directly with the business unit head, who is also in the mainland.
 
“Some staff in mainland companies, and even senior executives, need guidelines, and that’s why you must go there to teach them what should and what should not be done,” says Tong. “Fortunately, most of them are good students.”
 
Turn the visit into an opportunity for a personal chat, rather than an investigation by a harsh CFO. Tong suggests questions such as “Are you satisfied with the work?” “Do you have any question about the accounts” “How is the cash flow recently?”
 
Some industry sectors in China can be more complicated than others. “The assets of agricultural and mining companies are quite tricky to value,” Tong points out. “They may be worth $1 billion today, but only $100 million tomorrow. It all depends on the reports of experts, to whom financial professionals should pay more attention.”
 
The pharmaceutical sector be a minefield too. “Some healthcare companies have amazingly high costs and hidden expenses,” says Tong. “Most of the money is paid to hospitals and doctors as commissions. People in the industry have a saying:  no commission fees, no turnover.”
What Can the CFO Do?
Tong suggests a three-pronged approach:
 
Set a clear policy. The CFO should make clear what constitutes fraud and violations of good corporate governance, including bribery. The consequences should likewise be made clear if anyone in finance and others in the company, including top leaders, commit illegal acts.  
 
 “Whether they will be fined, fired or turned over to the police, it’s better to have these clearly written down point-by-point,” says Tong.
 
Set the example. Employees take the cue from the top leadership, so the behaviour of the CEO, CFO and other senior executives will influence the company’s culture and integrity. ”Imagine that if the chairman and the CFO ask the employees to manipulate the accounts,” says Tong. “That would be the end of the company.”
 
Establish a hotline. Given the key role that anonymous letters play in alerting executives to corporate wrongdoing, companies should consider a management system to encourage such tips by establishing independent hotlines, for example.
 
“The hotline could reassure potential whistleblowers that they would not be ignored or identified,” Tong suggests. “More fraud may be uncovered.” The hotline need not be limited to a telephone line. An email address or post office box can be set up for the same purpose.