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

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.

One U.S. high-tech company with plans to become publicly listed showed signs of trouble when its independent auditor could not reconcile sales revenue. The company discovered that, during initial expansion into the international market, eagerness to record its first sale led unintentionally to an affiliation with a disreputable agent. The agent led members of the company to believe that conducting business in certain foreign locales required them to accept and authorize questionable business practices. Consequently, they made a series of highly questionable payments to government authorities who were in a position to influence the contract the company sought. Following this incident, those involved questioned whether the payments actually constituted bribery or if the company was simply the victim of a shrewd con game designed to siphon off agent commissions disguised as "illegal payments." Regardless, the company's exposure, left unaddressed, could eliminate any chance of becoming a registrant of the U.S. Se curities and Exchange Commission and subject the firm, as well as its officers, to penalties under the U.S. Foreign Corrupt Practices Act.

(4) GROWTH THAT EXCEEDS CONTROL LIMITS

"Our company has tripled gross sales in the last five years and, amazingly, we still have only three people in the internal audit department." Sound familiar? Many companies faced with the responsibility of managing growth fail to plan for the long term. While pursuing market share and revenue, firms sometimes neglect to invest in the infrastructure required to support business expansion.

Two large U.S. multinationals faced this problem when they invested in a continuous stream of international acquisitions. Although the firms created tremendous market strength in their industries, they invested very little in management awareness tools such as internal auditing, security, and risk management. The money they saved from shortcutting these critical components maximized the capital available for additional investments. Eventually, though, one of the companies identified balance-sheet irregularities from foreign operations -- the discovery occurred when mounting losses overcame foreign management's ability to hide poor performance. The second company experienced unexplainable shortages and management conflicts among its various Far East operations. Both firms required significant and costly reorganization of foreign operations to correct the problems.

(5) UNUSUAL BUSINESS PRACTICES

As a general rule, practices that do not constitute good business at home are also likely to be problematic abroad. A group of business partners learned this rule the hard way while attempting to establish fast-food franchises overseas. The group hired foreign-development agents to establish a marketing campaign and attract foreign investors. Although the partners were accustomed to using escrow agents for such purposes in their native country, they assumed that business practices differed overseas and agreed to the agents request for initial cash payment. The agents subsequently collected proceeds from foreign investors, but they never established the marketing campaign or opened the first store. The angry investors sued the partners who, in turn, are attempting to sue the distributors. The partners were duped largely because they failed to question whether good business practices, such as the use of escrow agents and transparent share ownership, applied outside their own country.