In China, the spotlight is increasingly turning onto foreign investors as economic uncertainty intensifies along with domestic political pressures. One consequence appears to be an increased awareness and campaign against fraud – and on the part of companies, an increase in the value placed on internal controls.
The Chinese business context holds increased risks for violation of certain aspects of internal control and a different understanding of implementation of internal control systems and internal audits. These are particular challenges for companies subject to compliance with a parent company’s code of conduct and/or regulations from other countries, such as the U.S. Foreign Corrupt Practices Act (FCPA).
Internal Control and Audit
As finance professionals know, internal control and audit are a pair – the former a process and the latter a check of the quality of the process.
The internal control process is designed to provide reasonable assurance of three objectives:
- Effectiveness and efficiency of operations
- Reliability of financial reporting
- Compliance with applicable laws and regulations
A fourth objective is safeguarding assets. In China, misappropriation of assets ranks among the most common issues arising from poor internal control.
An effective internal control system is monitored both continuously and with separate evaluations. This is where internal audit comes in. An internal audit evaluates the effectiveness of risk management, control, and governance processes from a systematic and disciplined standpoint.
In China, we have discovered that an internal audit commissioned directly by the company’s headquarters is the best way to uncover and prevent fraud in a China-based entity.
First and foremost, an internal audit engaged by the China-based entity itself reports only to that entity. If fraud is discovered at a local level, it may not be reported directly to company headquarters.
In one recent case, recounts Dezan Shira & Associates Audit Manager Ronin Lin, significant sales department fraud (including submitting fake invoices) was being willingly overlooked at the local level because the department was doing well. Since it was the local entity that ordered the internal audit, the audit team did not report the situation to headquarters abroad.
An internal audit of a China-based entity ordered by headquarters holds an additional benefit – maintaining trust and confidence between China-based management and staff. As the local management did not order the audit, there is no suggestion of faltering trust or loss of confidence.
“In addition to what’s required by law, audit comes in many forms,” says Lin. “We typically recommend one of two types of assurance to our clients: a ‘house check’ or a ‘full scope.’”
“In a ‘house check,’ we run through a general internal control checklist and try to gauge whether an organization is under control risk. This basically means that there is a predefined internal control protocol in place, and that an organization’s reports reflect reality. This type of assurance, which requires significantly less money and energy than a ‘full scope’ assurance, can determine whether the latter is necessary.”
Fraud Risk in China
More than a few people have paused to consider how fraud risk in China may be different from that in other geographic locations. The most widely accepted answer seems to be: “It’s not different. But…”
The opportunities for fraud in China are simply greater than in many other locations – business transactions are less transparent and the language barrier a thick shield. While anyone who suggests that Chinese culture has an influence on the prevalence of fraud will immediately be shot down – fraud is a product of humans acting in self interest and nothing else – certain characteristics of Chinese business culture can have a huge impact on fraud prevention.
It is widely acknowledged, for example, that contracts are seen as substantially less important in China than elsewhere. In addition, the approach that companies in China take in dealing with fraud may differ from that in other countries. Punitive action after fraud is discovered is often not as severe, which encourages fraud in the first place.
Fraud in China varies significantly, from petty cash fraud to very sophisticated fraud deeply entrenched in an organization’s operations. Internal control to protect intellectual property (IP) is increasingly a point of concern. Many companies in China have graduated from a manufacturing focus to a model where their real business value is in their intellectual property.
“Fraud risk can also vary significantly with the complexity of an organization’s structure,” according to Lin. A foreign-invested commercial enterprise, or FICE, which typically functions as a trading company, can make do with a straightforward internal control system. But more needs to be done with organizations that do a lot of marketing and those that deal with many vendors and a complex supply chain, because they have a higher risk of fraud.
Even with the simplest business model, inappropriate behavior uncovered by internal audits can go quite deeply. Lin recalls another recent internal audit engagement which uncovered contracts showing that a general manager was renting his own houses to the joint-venture company (without the slightest rationalization for how this was related to business operations).
The twist to the situation was that the GM himself was one of the majority shareholders of the joint venture (and, needless to say, the only one aware of the rental contracts).
Operations with elevated fraud risks within China-based enterprises include supply chain management, payroll management, and sales.
- Purchasing of overpriced raw materials (due to relationship/inappropriate agreement between staff and supplier)
- Improper disposal of scrap
- Fake VAT invoices
- Poor inventory control
- Discrepancy between contract salary and payroll payments
- Deliberate over-accrual/unauthorized use of welfare benefits
- Ghost employees
- Unauthorized/improper reimbursements
- Non-payment of taxes and social security
- Sales of goods at/below cost (due to relationship/inappropriate agreement between sales staff and purchaser)
- Payment of unauthorized sales commissions to employees or friends
- Lack of competitive bidding process
For foreign-invested enterprises in China, preventing fraud means increasing vigilance in strengthening internal control systems. Fraud prevention should be based on the ‘fraud triangle’ of opportunity, motivation and rationalization.
Opportunity: Internal control is focused on limiting the opportunity corner of the fraud triangle. A key example is strengthening the physical security of inventory – not what’s on the books, but the systems in place to carefully monitor what enters and leaves a facility.
For example, a China-based clothing manufacturer ordering huge quantities of fabric had an employee who was purposely mislabeling good material as scrap – and selling the mislabeled fabric at a low price to a separate company to produce counterfeit goods.
Motivation: Recruitment is one area that allows you to expand into the motivation corner of the fraud prevention triangle. Pre-employment screening should be done for all sensitive posts, i.e. those in the ‘fraud potential zone’ – including senior positions in the finance and procurement departments, as well as sales, supply, marketing warehousing and distribution.
Pre-employment screening can be challenging in China because labor laws favor the employee. If a company discovers fraudulent behavior, it may choose to protect itself from any potential litigation and sign a mutual-termination agreement with the errant employee.
If a prospective employer asks the employee why they left the post, he or she will probably vaguely say that it was a mutual decision. A discreet investigation can figure out if unethical behavior was in fact the cause of termination.
Rationalization: The rationalization corner of the fraud prevention triangle is hardest to deal with in internal control. This refers to individuals who rationalize the fraud because they say they are underpaid, for example, or because they intend to put the money back before anyone notices.
One place to start in considering rationalization is procurement staff and suppliers, who often deal with thin profit margins and may be tempted to rationalize their commitment of fraud. A closer look can clarify whether procurement staffers are acting in the best interests of the company and suppliers are following their original contract obligations.
Below, we provide an internal control checklist to help foreign enterprises in China limit their risk of fraud while operating in the country.
Legal establishment appointments
When establishing a legal entity in China, consider carefully who is appointed as legal representative, general manager and executive director, their relationship to yourself and to each other. While smaller companies may name one person as general manager and executive director, the position of legal representative is particularly powerful and no one person should fill all three roles.
Business license and chops
To carry out many business activities in China, you will be required to produce your original business license and chops – the company’s official seal. Depending on the firm’s business scope, you may have a company chop, a financial chop (for large payments such as salaries and rent), and perhaps contract, customs, invoice and parent-company chops.
You need a plan to ensure the license and chops are accessible but also controlled. One person should not have control over all of them. A disgruntled employee, for example, may use the company chop to hire ten relatives as employees, to whom you will then be forced to pay severance.
Ensure that you possess the documentation proving you own your business’s registered intellectual property in China, in both English and Chinese.
Accounting checks and audits
Have a third-party accountant check your books at least every quarter (or monthly, if the amounts are high). This does not just help keep your staff in China honest; professional accounting firms can also help with tax policies and procedures that can bring financial benefits to your business.
Inventory on the books and actual inventory in the stock room are not always the same. Keep these two as close as possible with frequent stock-taking.
Keep an eye out for collusion between staff members in the accounting and inventory departments. Collusion of this sort can cover up large-scale fraud that is very difficult to detect.
Recruitment and payroll
Ensure that unethical behavior was not a cause for termination in a previous employment, particularly for senior posts in finance, contract and procurement, sales, supply, marketing, warehousing and distribution.
After hiring, watch out for payroll inconsistencies at all levels. Payments may be made to non-existent employees (whose salary is often sent to a bank account of another employee).
Purchasing, sales and distribution
Conduct due diligence on vendors and suppliers to ensure they are following original contract obligations and that the procurement department is acting in the best interest of the company.
Procure outside assistance to check if sales employees are discounting for bribes or partnering with distributors to centralize distribution channels.
About the Author
Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. This article was first published in Asia Briefing
and was reedited for clarity and conciseness. For further details or to contact the firm, please visit www.dezshira.com.
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