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Watch for fraud in the supply chain

Corruption in procurement not only costs companies dearly but also erodes the general fabric of society

Author: David Lehmann

dlehmann

The supply chain is the one area in any organisation that is most vulnerable to fraud and corruption. While an organisation can put controls in place to reduce illicit rebates, kickbacks and dubious vendor relationships, the risk of it occurring can never be fully eliminated. Instances of fraud and corruption in the supply chain cycle are not easy to detect, prove or prosecute.

The economy of Malaysia is heavily reliant on supply chain efficiency. Malaysia has a large manufacturing base and according to Ministry of International Trade (MITI), for the period January to September 2009, it exported almost RM160 billion in electrical and electronic products alone. To maintain viability and profitability, this and other industry rely heavily on reliable and efficient supply chains. During a normal business cycle, a high-risk fraud environment is typified by pressure, rationalisation and opportunity. These factors have been exacerbated by the global economic slowdown since December 2007.

In a climate where many organisations were forced to lay off employees, it increased the pressure on individuals to meet and maintain previously experienced growth targets. In these circumstances, it is easier for individuals to rationalise unethical behaviour as an essential means to an end - that is, to ensure personal financial survival. All that is needed to complete the infamous so-called 'fraud triangle' is the opportunity to commit fraud or corruption.

Temptation

Such opportunities exist in all organisations - for unethical individuals, it is simply a matter of finding them. As such, it is just a matter of time before an organisation becomes the victim of fraud or corruption. When this happens, an organisation often does not even know that it is being targeted.

Under these conditions, and especially in light of the fact that paying bribes is seen as part of the business culture in some parts of South-east Asia, employees who are requested to pay or are offered a bribe may find it difficult to resist the temptation.

If they do decide to pay a bribe, they won't use their own money; they will use yours. This typically means that they:

  • will have to divert the funds from somewhere and will thus have to commit fraud in order to create or hide the payments
  • may need to get someone else involved to circumvent internal controls.

To preserve the reputation of the organisation, management often elects to deal with such instances internally and allows implicated employees to 'resign' with their reputations intact. While this may not have demonstrable negative effects on the organisation at the time, it increases its vulnerability in the long run, because it:

  • sends the wrong message, i.e. that fraud and corruption does not have any real consequences for those that commit it
  • erodes the general fabric of the society in which the organisation conducts its business, in that a proven fraudster or corrupt person is allowed to carry on with his illicit activities and spread the contagion of corruption further. In public procurement, it also means that money which should have been used for the community’s benefit is going into the pocket of a government official
  • has the potential to further expose your or another organization to the fraudulent behaviour of the same individual, as he could end up being employed by a supplier or customer.

Apart from the financial implications of fraud and corruption, which can be severe, the fallout from a reputational perspective can be disastrous, particularly for listed entities. In addition, corruption increases the cost of doing business, undermines competitiveness and prohibits economic growth. These negative consequences apply equally to the public and private sectors. In addition to these risks, the dishonest acts of an individual or individuals may also expose your company to civil or criminal liability under domestic or foreign corruption legislation, e.g. the Malaysian Anti-Corruption Act 2009 and or Foreign Corrupt Practices Act 1977 (US).

The Organisation for Economic Cooperation and Development (OECD) estimates that governments in the Asia Pacific region pay 20-100 per cent more for goods and services because of corrupt procurement practices. This represents a substantial diversion of public funds, as procurement amounts to up to 20 per cent of public expenditure. It means that governments have far less money to fund the infrastructure, education, health and other public investments needed to reduce poverty and deliver much needed public services.

A World Bank study estimates that Malaysia loses around RM10 billion to fraud and corruption annually, somewhere between 1-2% of GDP. A large portion of this occurs within the procurement function, whether in the private or public sector. Even if this was cut by 20% it represents a large amount of money that could be utilised for worthwhile community programs.

Not surprisingly, corruption matters to consumers. Half the respondents interviewed for the recently released 2009 Transparency International Global Corruption Barometer indicated that they perceived the private sector to be corrupt, and that they would be willing to pay more to buy from a company that is corruption-free. This represents an increase of eight percentage points compared to five years ago. This sends a clear message to the private sector that being clean pays off. This message has not gone unheard by the private sector. The World Bank's investment climate survey shows that firms with interests in the Asia Pacific region view corruption as a major or severe obstacle to the operation and growth of their business.

Red flags

The supply chain presents many opportunities for fraud and corruption. From procurement to distribution, employees and external parties, such as suppliers, distributors and competitors, all have opportunities.

These range from false invoicing, bribery and kickback schemes to inventory theft and sale of substandard goods.

Some of the 'red flags' to look out for include: 

  • Poor or non-existent record keeping, e.g. expense reimbursements 
  • Political or charitable donations tied to agents 
  • Higher-priced/lower-quality goods 
  • Excessive entertaining of procurement staff by suppliers 
  • Deviations in communications between procurement staff and suppliers, such as calls or text messaging to mobile phones 
  • Procurement staff demanding extended periods of notice before they allow an audit to take place or repeated requests for postponement 
  • Inexperienced buyers dealing with overbearing suppliers, especially in conducting business in Asia 
  • Staff not taking leave 
  • Preference given to selected suppliers regardless of pricing and quality.

While the risk of fraud cannot be eliminated entirely, it can be greatly reduced with the right approach.

South-east Asia's trading environment provides many business opportunities. In order for these to be fully exploited, investors must exercise a degree of caution and approach each opportunity with scepticism.

If appropriate prevention and detection methods are not implemented, organisations may suffer loss of revenue and profit. Routine checks for non-deliveries, repeat deliveries for the same order and discrepancies between purchase orders and delivery are a few of the procedures needed to reduce fraud risks.

Prevention is always better than cure. The amounts paid to settle any claims resulting from exposed fraud will always be secondary to the loss of reputation and integrity that companies may suffer for being associated with such claims.

In the long term, money and effort spent on prevention minimises future losses and makes good sense.

David Lehmann is the Head of Deloitte Forensic at Deloitte Malaysia. Prior to joining Deloitte in 2004, he completed 23 years of service with the Victoria Police, Australia, with a majority of that time dedicated to the investigation of fraud-related incidents.

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