The biggest risk to shareholder value

A failure by most companies in Hong Kong to address all areas of the corporate fraud picture is leaving many exposed to what is potentially one of the most damaging types of fraud – institutional fraud.

Institutional fraud, also known as management fraud or “cooking the books”, has the potential to significantly damage ongoing company performance and shareholder value, and has led to the collapse of several companies listed on the Hong Kong Stock Exchange in recent years.

Yet despite the widespread adverse impact institutional fraud can have on a company’s ability to survive in today’s challenging economic conditions, the detrimental impact of this type of fraud is only now starting to come under increased scrutiny as more cases come to light.

Senior management is generally well aware of the risks and controls needed to protect the company against internal and external fraud. For example, most companies have introduced systems and controls to prevent or detect a situation where employees commit fraud against the company for their own gain. Companies understand that such instances could potentially bring about financial loss and reputational damage to the company. The same can be said about external fraud, where a third party colludes with employees of a company for monetary or commercial gain.

However, one of the most common oversights by senior management is in protecting the company from the occurrence of institutional fraud, which includes misrepresentation of the financial performance of companies. This exposure can perhaps be attributed to the fact that those responsible for the design and implementation of the anti-fraud framework could very well be the same individuals who could damage the company’s shareholder value.

Part of addressing this involves companies ensuring that a complete fraud risk assessment is undertaken, with significant input from the independent directors, as part of the creation and maintenance of their anti-fraud framework and controls. This is one of the steps that companies could adopt to mitigate the occurrences of institutional fraud – a step that we are not seeing enough of in Hong Kong.

In May this year, the US Rand Centre for Corporate Ethics and Governance released a report that focused on delivering analysis and recommendations from a broad range of compliance experts, prosecutors, judges, accountants and government officials. One of the key findings of the report was that, since 2002, the US Department of Justice has convicted 200 CEOs, 120 VPs and 53 CFOs of criminal misconduct. Another survey referenced in the same report suggested that in more than four out of five incidents of corporate fraud studied, the senior managers either knew about it or were the ones who committed it.