Forensic accountancy

Missing the elephant in the room in China-related matters

Investigative professionals often enter into investigations in which other professional services firms have already been engaged and working for some period of time. The reason new professionals get brought into the picture is that the original professionals have missed some key element to the investigation. Typically this stems from over-focusing on one particular aspect of the matter while missing more important aspects of the case. The original professionals are likely intelligent and experienced (otherwise they would not have been there in the first place), but unless one is able to take a step back from a situation and periodically reassess it, there is the risk of missing something crucial.

There are many reasons for this but two common ones typically emerge. First, one may not fully appreciate or even be aware of the human and psychological elements that run at the core of investigative matters, specifically the subtle, yet insidious, influence of bias. If left unchecked, bias can easily send an investigation off track. Second, one may not fully understand the key evolving economic and business drivers of a company's operations. In such case the problem may emerge in the form of an over-emphasis on well-trodden ground focusing on past risk issues while missing emerging new risk areas and patterns. Again, if left uncorrected, an investigation can get off track.

The subtle influence of bias and how to avoid it

The concept of bias is not necessarily negative per se as bias comprises a natural part of our human makeup and at a fundamental level serves as a survival tool. As early humans explored the world around them, they learned to develop perspectives on what may be dangerous and what is not. A bias may be positive or negative. The key thing is to recognise when we have them and how they may be influencing our decision-making and actions. Periodic self-reflection is required to prevent the subtle influence of bias.

There are three common types of bias: stereotype, prejudice and discrimination.¹ A stereotype is an exaggerated belief, image or distorted truth about a category of people or an individual member of that category, and a stereotype can be positive or negative. For example, if you see a person wearing eyeglasses and holding a book, would you automatically assume that person to be intelligent? Would you be surprised to learn that the apparent bookworm was actually just carrying the book for someone else and not interested at all in reading? Stereotypes are generated - and reinforced - from a number of sources. In our youth they can be passed on by parents and family members. They can be generated, reinforced and perpetuated in our social groups, from respected individuals, and in mass media (including ‘fake news').²

Both stereotype and prejudice can lead to discrimination, which is behaviour that treats people unequally based upon their group associations or affiliations. Such unequal treatment again may be positive but more often is seen in its negative applications, like discrimination experienced in the workplace. Thankfully, in this regard, leading organisations are now actively taking steps to address discrimination in the workplace as it has a deleterious effect on morale and productivity.

If left unaddressed and unchecked bias of all three forms can have negative consequences on an investigation by leading the line of inquiry far off the mark. For example, a bias regarding the guilt (or innocence) of someone alleged to have committed some wrongdoing can let the actual perpetrator off the hook while simultaneously wasting time and effort focused on the wrong person.

Bias can creep into and impact an investigation as investigators form a hypothesis of who may have committed the wrongdoing. In fact, it can be easier for an investigator to focus on proving the allegation rather than uncovering and analysing all the relevant the facts (which may lead away from the initial target).⁴ Investigations are by nature iterative activities, and in order to proceed effectively investigators do need to develop an initial hypothesis (and subsequent hypotheses as new facts come to light) as to who committed the wrongdoing. However, investigative and compliance professionals need to be aware that in the very act of establishing a particular hypothesis they may be setting biased thinking on their part as they proceed to analyse and interpret additional data and facts as part of the ongoing investigation. They may view incoming information only from the (biased) perspective that supports their initial hypothesis, and correspondingly fail to see what is obvious if they are wrong.

Investigative professionals also need to guard against bias affecting interviews. How questions are prepared, how they are asked, how the dialogue proceeds and evolves during an interview can all be deeply - and subtly - influenced by bias, especially as described above. By being fixated on the guilt (or innocence) of a particular individual or being fixated on a particular method by which fraud occurred, the risk emerges again.

Sometimes bias applies to the overall approach to an issue beyond just the initial hypothesis of who did what and how they did it. In investigative matters sometimes the most impactful issues are not the ones of initial focus. This may happen more often than we realise, as investigations are by their nature iterative processes. As investigative matters tend to be high-stakes issues with great pressure to find the answers and get to a resolution, it is not wholly unexpected for a bias to quickly develop in terms of overall approach to the investigation and perceived key issues. Sometimes client personnel will have their own biases and may (unintentionally) influence the scope of work. Nevertheless, investigative professionals should take it all in stride, avoid getting sucked into a particular line of thought or hypothesis without taking an objective look at the facts of the matter, and focus on identifying and clarifying additional necessary facts. The facts themselves may actually point to other issues entirely and lines of inquiry outside the initial areas of focus. Some hypothetical examples are illustrated below.

Example 1

An internal investigation in response to whistleblower allegations of conflict of interest and self-dealing on the part of a sales manager focuses solely on establishing the sales manager's ownership ties to certain agents and distributors and the benefits accrued from them to the individual sales manager. The investigation looks only at the ethical issues involved around conflict of interest; however, what gets missed is the fact that the third parties in question all sell solely to government clients and the parent company is an SEC issuer and thus subject to the FCPA. Addressing conflict of interest issues are important in an organisation, but the bigger issue in this case is FCPA compliance. The self-dealing is an issue worthy of attention and remediation in itself, but actually serves as the means for the corruption issue that has a greater potential impact on the parent or group company in terms of its regulatory obligations and related reporting requirements.

Example 2

Following an M&A transaction a buyer is trying to figure out post-closing price adjustments based on warranty claims as stipulated in the share purchase agreement (SPA). The buyer's initial professional advisors remain fixated on the parameters of the SPA and have come up with some previously unrecorded expenses in nominal amounts, but are perplexed by a payment received purportedly from a major client. Bank transfer information shows that funds actually came from the spouse of the recently departed CEO (who was one of the sellers). The buyer's initial professional advisors cannot figure out how payment into the company could be fraudulent. However, taking a step back and looking at the underlying purported revenue transaction in context, the transaction occurred just at the right time and just in the right amount for the sellers to show a net profit in the monthly management financials sent to the buyers just prior to acquisition closing. Without booking this revenue transaction, the company would have shown a loss and would have jeopardised the deal for the sellers. Post-closing, with the legacy CEO and CFO still in place, the cash payment was made in order to avoid scrutiny over the original revenue transaction. This led to further examination of the acquired or target company's accounts receivable yielding a discovery that half of the balance at close was bogus. Instead of nitpicking over relatively minor warranty claims the buyer then had grounds to file for recession.

Another iteration of bias towards overall approach may come in the form of fixation on a particular method without considering its suitability to the matter at hand, as illustrated below.

Example 3

A professional firm gets retained in an investigative matter involving allegations of fraud. As with other investigative matters an initial step consists of gathering electronic documents and communications (emails, text messages, etc) from key relevant persons (referred to as ‘custodians' in e-discovery parlance). The collection of electronic information takes place and then the professional firm in turn retains a low-cost outsourced document review services provider to conduct an initial review of the documents. Use of such outsourced vendors is common practice as the goal in their utilisation is to contain overall investigative costs. However, the outsourced service provider utilises junior people to conduct the review who may not have even had any fraud investigation experience. Furthermore, as investigations tend to be iterative processes and at the initial stages of the investigation the modus operandi of the purported fraud has yet to be fully discerned, the outsourced junior reviewers have very little to go on in terms of specific instructions of what to look for. Lacking in sufficient experience and instruction to spot the clues to potentially relevant issues, such reviewers simply don't know what they don't know. The result is that they miss the key issues entirely.

Although the approach in this above example - using outsourced resources for document review - can and does make sense when search parameters are clear and defined (such as in a litigation matter when the issues in dispute are themselves well defined) such an approach is less suitable for the early stages of a fraud investigation (or due diligence matter) when the key issues - consisting of who did what, where and when - are not yet clearly defined.

Before moving on, it's worthwhile to examine ways one can overcome bias. An investigator should aim to be:⁵

• able to suspend judgement - one should wait to form judgements until sufficient evidence has been obtained and considered;
• informed - one should not be satisfied until all relevant data has been reviewed and understood, including any facts that may conflict with an existing hypothesis;
• ethical - one should always seek the truth, no matter what the facts indicate, and should not be easily influenced or swayed;
• self-confident - one should not be easily deterred by the latest piece of information or attempts at persuasion by parties of interest;
• persistent - one should not give up easily in seeking the truth, even if information is difficult to obtain and one meets resistance from those who should provide it;
• perceptive - one should constantly be alert for incongruous statements or new information, be able to connect the dots, and identify patterns in behaviour and data; and
• an effective communicator - one should be able to clearly express oneself, but a critical component of this calls for being an active listener able to observe and absorb all information being provided by an interviewee, without coming across as adversarial.

Understanding the key evolving economic and business drivers of a company's operations

Another critical element that may lead to missing the elephant in the room stems from simply not fully understanding the evolving drivers of a company's business. This then results in an inaccurate or incomplete risk profile for the company, which in turn may lead an investigation off course. The dangers are even greater in proactive compliance and internal controls assessments as well as due diligence matters owing to the lack of pre-existing allegations or some other known indications of potential fraud or wrongdoing in such matters. In fact, it's in these types of matters where understanding a company's key economic and business drivers becomes critical.

Just as a rising tide lifts all boats and a receding tide uncovers the rust on the hull, macroeconomic conditions influence the generation of different types of fraud. China's economy is undergoing a fundamental shift similar in magnitude similar to when it first launched its market-oriented reforms in 1979. The impact of this deserves careful attention. Despite the strong officially reported GDP growth figures for the first half of 2017, China's economy continues on a long-term chronic slowdown and the underlying trends point to more challenges ahead. China's economy simply relies too much on debt-fuelled construction. A New York Times article aptly put it, ‘a sizable chunk of China's economy may depend these days on building roads and rail lines into the desert using borrowed money.'⁶ Economic growth driven by these factors remains unsustainable and points to slower growth rates over time. Reliance on debt-fuelled growth cannot be maintained as China needs to enact a critical deleveraging of the debt in its economy in order to avoid a financial meltdown. As China's economy continues its inevitable downward trajectory, operating and liquidity pressures will build, producing a continued high volume of fraud and corruption matters, but the nature and characteristics of these will change.

The anaemic economic environment places increasing business and operating pressures on owners and managers in China (both foreign and domestic) while at the same time these managers face continued and increasing market pressure to deliver results. Perception also plays into the pressure on managers to deliver results. Despite the readily apparent trends described above, recognition of China's evolving economic situation lags behind reality. The widening disconnect between expectations for a company's business prospects in the China market and the reality of the economic shift underway put pressure on management teams to meet increasingly unrealistic expectations. Managers in China will need to address gaps in meeting projections and forecasts, while at the same time needing to address access to liquidity and broader strategic corporate issues pertaining to closing exit windows (via mergers and acquisitions, and capital markets). As China's slowing economy widens the gap between perception and reality, there will be ever more pressure for managers to do whatever it takes to close that gap in order to meet forecasts, obtain liquidity, and pursue corporate development objectives.

In any case, simply being under pressure (or having the desire or intent) to commit an act of fraud is not enough; one also needs the opportunity to act, as well as a reason for such acts. Weak corporate governance practices and underdeveloped internal controls can be common among companies in China (including foreign-invested ones), and these open the door to opportunities to commit fraudulent acts.

A perfect storm for corruption

China stands out as a leading source of corruption cases. There are several key factors that have combined to make the perfect storm for corruption in China: the importance of China for global business, China's chronic corruption problem, increased enforcement by regulatory authorities, and now, China's slowing economy (as discussed above).

It's no secret that China has been a priority market for multinationals and global private equity firms for many years, but now the China market is losing its lustre. Coming in various waves over the past two decades, foreign investment helped drive China's dramatic economic development, and at times China has even rivalled the United States as the world's top foreign direct investment destination. With the sheer volume of foreign investment there is much more exposure to risks from China's chronic corruption problems as multinationals enter and try to navigate the Chinese market.

China is not unique in being a developing economy with corruption issues; however, what is unique is the sheer size of its economy combined with the pervasive direct role the state plays in it. Despite reforms, approximately half of its GDP remains state-owned or controlled. Even ostensibly private domestic companies may actually be state-owned or controlled (in full or in part) through state ownership in their group organisation structure (for example, from local-level holding companies of the State-Owned Assets Supervision and Administration Commission). In addition, truly private companies with no state-ownership are often also heavily influenced by local government. Following major reforms in the 1990s there have been no major moves since then towards the widespread removal of the state's direct role in the economy. Essentially, China's economy remains stuck in transition, and this is a fundamental root cause of China's chronic corruption problem.

Evolving corruption schemes

When China-related FCPA cases first started to emerge in the early to mid-2000s, conducting investigations was relatively straightforward. Personnel in China were typically completely unaware of anti-corruption compliance. In combination with this, the business culture has also long been characterised as one of excessive gift-giving and entertainment. As such, relevant transactions were often readily transparent in a company's books and records. For example, it was common to see transactions clearly recorded in the general ledger with descriptions such as, ‘gifts of alcohol and tobacco to government officials'.

As corruption cases became more frequent and visible, multinationals started to require anti-corruption due diligence as part of any prospective deal. Concurrently, compliance programmes evolved from a simple ethics statement to a fully fledged package of detailed policies and supporting procedures. Through this evolution, awareness of anti-corruption issues grew among employees in Chinese operations. As awareness of bribery and corruption issues increased, the methods for making and disguising corrupt payments evolved as well.

Early FCPA matters in China drew attention to gifts, entertainment and travel provided to government officials. Compliance programmes now typically contain provisions asserting controls and company guidelines for these types of activities, and in rolling out FCPA compliance programmes these constitute the low-hanging fruit. However, with the increased awareness of corruption issues in China, there has been a general shift in corruption-related schemes from relatively higher-volume and lower-dollar-value schemes (excessive meals, gifts and travel), to relatively lower-volume and higher-dollar-value schemes involving more creative, non-­transparent approaches (such as increased use of third parties and schemes similar to embezzlement methods).

One example of this involves the creative use of third-party consultants in response to greater scrutiny of fictitious supporting documentation (in the form of official tax invoices). Fictitious receipts can be a common occurrence in China, and it was common to find fake invoices available for sale from street vendors. However, in recent years the Chinese tax authorities have cracked down on the use of fake invoices by implementing online databases that allow their validity to be checked. We have noted an approach developed in response to this stricter environment utilising a series of different third-party consultants over brief durations for the same scope of work. A consultant would be hired by a high-risk function in the company for a high-risk scope of work, such as interfacing with government officials. The consultant would issue valid, officially registered invoices, so from an initial examination of the company's books and records no red flags would appear in the form of fictitious receipts. However, the consultant would then depart after a brief duration (less than a year) and would be replaced by another consultant with the same function and scope. In addition, these series of consultants would essentially be start-ups with no history, track record or recognisable brand in the market; highlighting the need for substantive due diligence on intermediaries and third parties.

Looking ahead to assessing corruption risk for companies with operations in China, there are two main areas around which to conceptualise the risk: ‘revenue' and ‘regulatory'. By ‘revenue', I mean to what extent the company's revenue is dependent on government clients (including state-owned or controlled enterprises), and by ‘regulatory', I point to the licences and permits needed to open and conduct business. Generally speaking, the ‘revenue' side brings greater risk. The reason for this is that there are many more moving parts to the company's compliance programme stemming from the simple fact that there will be more nodes of interface between company (sales) representatives and ‘government officials'. An example of this is the healthcare sector in China that is nearly entirely state-owned, making every doctor or healthcare provider a ‘government official'. Correspondingly, if a company sells only into the private sector, but still faces ‘regulatory' issues all companies face in China in order to obtain and retain business licences, the risk is the risk is relatively lower in comparison because there is much less contact with government officials. Often these areas of interface are readily identifiable to just a handful of individuals within a company's organisation rather than extending to the entire sales force. It is important for investigative and compliance professionals to have this understanding, otherwise they can miss an important issue.

The resurgence of financial integrity and quality of earnings issues

In the course of China's development, the spectre of financial fraud has always loomed large. The issues have tended to come in waves, from the early days of private equity investment in China and the related war stories, to the more recent wave of fraud allegations pertaining to Chinese reverse-merger companies. However, with China's economy at a turning point, we can expect to see a resurgence of financial integrity and quality of earnings issues, and these may eventually take centre stage over corruption.

The appreciation of the magnitude and impact of China's structural economic shift (ie, chronic slowdown) has been slow in coming, and this has set the stage for an increasing disconnect between business plan expectations and the actual market realities on the ground. As this disconnect increases, some management personnel will feel increasing pressure to do whatever it takes to close the gap. In this regard, as economic pressure mounts, one can expect to see a re-emergence of classic financial statement fraud issues as well as more sophisticated schemes designed to pacify regulators, attract and retain investment, and maintain access to liquidity. Managed earnings as well as aggressive and fraudulent accounting practices are likely to be an increasing reality in China.

Indeed, an indicator of this has already emerged through the increased number of proceedings by the Enforcement Division of Hong Kong's Securities and Futures Commission (SFC). Recently the SFC expressed three major enforcement priorities for listed companies: IPO fraud and sponsor misconduct, false or misleading financial statements, and corporate governance failures. A recent enforcement case illustrates typical financial integrity issues, revolving around earnings. In this example (pertaining to Greencool Technology Holdings, Ltd) dating from December 2016 and June 2017, Hong Kong's Market Misconduct Tribunal found that ‘4 former senior managers disclosed false/misleading info about Greencool's sales, profit, trade receivables and bank deposits in a massive fraud'.⁷

Fraud methods in China have tended to be relatively simple. In order to inflate revenue or overstate assets, perpetrators simply fabricated transactions. However, as with corruption matters, the methods related to financial integrity issues are likely to evolve, involving more complicated business patterns with harder-to-detect fraud schemes and creative accounting methods (such as using third parties to inflate revenue and hide liabilities).

Common issues in China-related fraud cases include:

• fabricating transactions;
• inventing non-existent customers;
• recording fictitious or inflated revenue;
• overstated or non-existent assets;
• side letters with customers;
• fabricating cash records to cover bogus sales;
• use of related parties to manipulate profits or record fictitious revenue; and
• collusion with, and corruption of, banking officials.

In conclusion

Investigative and compliance professionals need constantly to be aware of the key factors that may lead them to miss a vital component of the investigation. Awareness comes from understanding and reassessing the facts and circumstances of any given situation, as well as periodic self-reflection to ascertain the influence of any bias. In an age where we increasingly look to technological solutions to solve our problems - including conducting investigations - the human factor still proves the most important.

Notes

1. Association of Certified Fraud Investigators, ‘Overcoming Bias in Investigations and Audits'.
2. Association of Certified Fraud Investigators, ‘Overcoming Bias in Investigations and Audits'.
3. Association of Certified Fraud Investigators, ‘Overcoming Bias in Investigations and Audits'.
4. Association of Certified Fraud Investigators, ‘Overcoming Bias in Investigations and Audits'.
5. Association of Certified Fraud Investigators, ‘Overcoming Bias in Investigations and Audits'.
6. New York Times, ‘Predictably, China's Year-on-Year Growth Maintains Its Steady Pace,' 16 July 2017.
7. Hong Kong Securities and Futures Commission, presentation given at the HKICPA on 19 July 2017, ‘SFC enforcement trends & priorities: corporate misconduct & fraud'.