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Good Corporate Governance: Good Corporate Governance: Essential to Prevent Essential to Prevent

ConflictsConflicts of Interest and Fraudof Interest and Fraud

PakistanPakistan’’s Experiences Experience

By: Asad Ali Shah By: Asad Ali Shah Partner, Deloitte Pakistan Partner, Deloitte Pakistan

Council Member, Institute of Chartered Accountants of PakistanCouncil Member, Institute of Chartered Accountants of Pakistan

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Presentation OutlinePresentation OutlinePakistan & Corporate SectorPakistan & Corporate SectorConflict of Interest & FraudConflict of Interest & FraudWhy Conflict of interest is so harmful to the organizations Why Conflict of interest is so harmful to the organizations & economy & economy Cost of Fraud to the economy & organizations Cost of Fraud to the economy & organizations Fraud TriangleFraud TriangleCorporate Governance (focusing on anti fraud ) framework Corporate Governance (focusing on anti fraud ) framework in Pakistanin Pakistan

Ethics / Conflict of interest related provisions in the Ethics / Conflict of interest related provisions in the Companies LawCompanies LawCode of Corporate Governance for listed Companies / Code of Corporate Governance for listed Companies / conflict of interest related provisionsconflict of interest related provisionsTransparency, Disclosure and Financial ReportingTransparency, Disclosure and Financial ReportingCompliance mechanismsCompliance mechanisms

What more needs to be done / way forward for fraud What more needs to be done / way forward for fraud (conflict of interest) prevention(conflict of interest) prevention

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About PakistanAbout Pakistan

Second largest country in South Asia/ Second largest country in South Asia/ Subcontinent.Subcontinent.Population : 165 MillionPopulation : 165 MillionGDP US $ 155 BillionGDP US $ 155 BillionPer Capita Income US $ 935Per Capita Income US $ 935GDP growth : 7%, in last five years, one of the GDP growth : 7%, in last five years, one of the highest growth after China & India in recent highest growth after China & India in recent years.years.

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PakistanPakistan’’s Corporate Sector & s Corporate Sector & Market ProfileMarket Profile

Three stock exchanges, KSE being the largest and Three stock exchanges, KSE being the largest and main market.main market.

KSE KSE –– consistently one of the best performing consistently one of the best performing market during last five years. market during last five years.

650 listed companies650 listed companies

Second largest Market / Economy in South AsiaSecond largest Market / Economy in South Asia

Market cap of US $ 75 billion, 50% of the GDPMarket cap of US $ 75 billion, 50% of the GDP

Over 50,000 public (nonOver 50,000 public (non--listed) and private listed) and private companies companies

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Conflict of InterestConflict of InterestA conflict of interest occurs when a person or organization A conflict of interest occurs when a person or organization acts on behalf of another individual or organization; and has, acts on behalf of another individual or organization; and has, or appears to have, a hidden bias or selfor appears to have, a hidden bias or self--interest in the interest in the activity undertaken; and the hidden bias or selfactivity undertaken; and the hidden bias or self--interest is interest is actually or potentially adverse to the interests of the actually or potentially adverse to the interests of the individual or organization being represented; and the hidden individual or organization being represented; and the hidden bias or selfbias or self--interest is not made known to the individual or interest is not made known to the individual or organization being represented. organization being represented. When a person's conflict of interest results in economic or When a person's conflict of interest results in economic or financial loss to the individual or organization on whose financial loss to the individual or organization on whose behalf the person is acting, then fraud has occurred. Conflict behalf the person is acting, then fraud has occurred. Conflict of interest can exist on its own, or can be an intricate part ofof interest can exist on its own, or can be an intricate part ofother frauds such as bribery and illegal gratuities. other frauds such as bribery and illegal gratuities.

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Conflict of InterestConflict of Interest

Actions resulting from Conflict of interest, Actions resulting from Conflict of interest, generally constitute most costly frauds, since generally constitute most costly frauds, since these happen at senior management / these happen at senior management / governance level.governance level.One of the objectives of Corporate Governance One of the objectives of Corporate Governance is to prevent fraud through enhancing is to prevent fraud through enhancing transparency, integrity and accountability.transparency, integrity and accountability.

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Fraud Defined

The term “Fraud” generally not defined in most jurisdictions.Although not specifically defined in criminal law, but every body seems to know what it is (except those who commit it, and purport to have no idea what they had done was wrong!).

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Fraud Definition It is like an elephant, Easier to recognize than to define.

An intentional act done by one or more individual An intentional act done by one or more individual among management, those charged with among management, those charged with governance, employees or third parties involving governance, employees or third parties involving the use of deception to obtain an unjust or illegal the use of deception to obtain an unjust or illegal advantage.advantage. (ISA 240 (ISA 240 –– ))

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Classification of FraudClassification of Fraud

CorruptionCorruption AssetAsset

MisappropriationMisappropriation

FraudulentFraudulent

Financial statements Financial statements

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FraudFraud-- statisticsstatistics

Measuring Cost of Fraud

• Determining the true cost of fraud & abuse is an impossible task, because fraud is a crime based on concealment.

• Some Frauds are never detected, or only caught after they have gone on for several years.

• Many frauds that are detected are never reported for variety of reasons, including reputation issue. And those that are reported, are often not prosecuted.

• Finally, there is no agency or organization specifically charged with gathering comprehensive fraud related information.

• All of the above factors combine to make an estimate of the total cost just that: an estimate.

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FraudFraud-- statisticsstatistics

2004 survey by Association of Certified Fraud of US on occupational fraud:Examiners

On an average, US organizations lose 6% of their revenue.

Estimated Loss US $ 660 billion a year – about $4,500 for every worker.

59% of frauds occur due to weaknesses in internal controls.

95% of US companies reported employee theft.

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Cost of Fraud?Cost of Fraud?

It's much less expensive to prevent an embezzlement than it It's much less expensive to prevent an embezzlement than it is to investigate one.is to investigate one.

According to one study, it is estimated that for each $ 1 lost According to one study, it is estimated that for each $ 1 lost due to any Fraud, the orgs lose an additional $ 4. due to any Fraud, the orgs lose an additional $ 4.

These calculations are conservative, and don't take into These calculations are conservative, and don't take into account other losses the org will ultimately suffer, including account other losses the org will ultimately suffer, including reputation loss.reputation loss.

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What Does Fraud Really Cost?What Does Fraud Really Cost?

To put it another way, each loss caused by internal or To put it another way, each loss caused by internal or external fraud costs at least five times the original amount:external fraud costs at least five times the original amount:

* * One dollar in actual cash or property value is lost;One dollar in actual cash or property value is lost;

* A second dollar is spent identifying how the crime was commit* A second dollar is spent identifying how the crime was committed;ted;* A third dollar is spent in identifying who committed the crim* A third dollar is spent in identifying who committed the crime;e;* A fourth dollar is spent prosecuting the person who committed* A fourth dollar is spent prosecuting the person who committed the the

crime; andcrime; and* A fifth dollar is spent in suing the person who committed the* A fifth dollar is spent in suing the person who committed the

crime for the recovery of the money taken.crime for the recovery of the money taken.

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Why Fraud is a Costly Business Why Fraud is a Costly Business ProblemProblem

Fraud Robs IncomeFraud Robs IncomeFraud Losses Reduce Fraud Losses Reduce Net Income $ for $Net Income $ for $If Profit Margin is 10%, If Profit Margin is 10%, Revenues Must Increase Revenues Must Increase by 10 times Losses to by 10 times Losses to Recover Affect on Net Recover Affect on Net IncomeIncome

LossesLosses…………. $6 Million. $6 MillionRevenueRevenue…….$60 Million.$60 Million

Revenues $100 100%Expenses 90 90%Net Income $ 10 10%Fraud 6Remaining $ 4

To restore income to $10, need $60 more dollars of revenue to generate $6 more dollar of income.

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FraudFraud-- statisticsstatistics

2004 survey by ACFE

Occupational fraud and abuse is widespread problem that affects practically every org, regardless of size, location & industry.

Most common fraud (over 90%) involves asset misappropriation. Examples are theft or misuse of assets such as stealing of inventory, cash, payroll fraud, skimming of revenues etc. The asset that is most frequently targeted is Cash.

Corruption, in which fraudsters wrongfully use their influence in a business transaction in order to procure some benefit for themselves or another person, contrary to their duty to employer or the rights of another. (common example include kickbacks, engaging in conflicts of interest.)

Fraudulent fin. Statements, were least commonly reported but arethe costliest. As against the median loss of $ 93k for asset misappropriation, median loss for fin. Statement fraud was over $ 1 million.

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FraudFraud-- statisticsstatistics

2004 ACFE Survey / Report to the nation

Losses caused by men are nearly four times those caused by Losses caused by men are nearly four times those caused by women.women.

Losses caused by managers are four times those caused by Losses caused by managers are four times those caused by employees.employees.

Losses caused by executives & owners are 16 times those of Losses caused by executives & owners are 16 times those of their employees.their employees.

While the occurrence of employee fraud was most frequent, While the occurrence of employee fraud was most frequent, the cost of the cost of fraudulent financial reportingfraudulent financial reporting was much higher.was much higher.

Small businesses are the most vulnerable to fraud and abuse

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Financial Statement FraudFinancial Statement Fraud

Financial statement fraud causes a decrease in Financial statement fraud causes a decrease in market value of stock of approximately 500 to market value of stock of approximately 500 to 1,000 times the amount of the fraud.1,000 times the amount of the fraud.

$7 million fraud $2 billion drop in stock value

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FraudFraud-- statisticsstatistics2004 ACFE Survey / Report to the nation

Fraud Detection

The most common method for detecting fraud:

By a tip from an employee, customer, vendor or anonymous source.

Among the cases that were detected by a tip, 60% came from employees, 20% from customers, 16% from vendors, and 13% from anonymous sources.

Orgs with fraud hotlines & anonymous reporting cut their fraud losses by approx. 50%.

Among frauds committed by owners & executives, which tend to be most costly, over half of all cases were identified by a tip.

Int. controls, int. & ext. audits, notifications by employees, Int. controls, int. & ext. audits, notifications by employees, background checks are the leading ways on uncovering frauds background checks are the leading ways on uncovering frauds with int. controls being the fastest growing method. with int. controls being the fastest growing method.

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Who Detects Frauds?

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Fraud Triangle

Heat

Oxygen Fuel

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Fraud Prevention at Macro Level.

Supply of motivated offenders• Reduce Supply of motivated

offenders.

• Educate the public/target.

• Reduce the opportunities.

Perceived Opportunity

Suitable target

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The Fraud Triangle The Fraud Triangle –– 3 conditions3 conditions

Perceived Perceived OpportunityOpportunity::

Circumstances exist Circumstances exist -- e.g. absence of controls, e.g. absence of controls,

ineffective controls, or the ineffective controls, or the ability of management to ability of management to override controlsoverride controls

Incentive/Pressure:

Management or other employees may have an incentive or be under pressure, which provides a motivation to commit fraud.

Rationalization/Attitude:Those involved in a fraud are able to rationalize a fraudulent act as being consistent with their personal code of ethics. Some individuals possess an attitude, character, or ethical values allowing them to knowingly and intentionally commit a dishonest act.

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Some Common Myths about FraudSome Common Myths about Fraud

It doesnIt doesn’’t exist in our organization.t exist in our organization.

If it does, it is not significant.If it does, it is not significant.

Most fraud goes undetected.Most fraud goes undetected.

Fraud prevention/ detection is the Fraud prevention/ detection is the responsibility of the auditors.responsibility of the auditors.

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Common MythsCommon Myths

Trustworthy staff.Trustworthy staff.Controls will prevent all fraud.Controls will prevent all fraud.Audits will detect all frauds.Audits will detect all frauds.

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ActuallyIT IS THE TRUSTED EMPLOYEES WHO

COMMIT FRAUDwhen they are given :

Responsibility:Authority: and

Independence without adequate monitoring.

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Regulation & Corporate Governance Regulation & Corporate Governance in Pakistanin Pakistan

Regulatory FrameworkRegulatory FrameworkRegulators includeRegulators include

Securities & Exchange Commission of PakistanSecurities & Exchange Commission of Pakistan--regulates all corporate entities and administers regulates all corporate entities and administers corporate laws.corporate laws.State Bank of Pakistan regulates banking sectorState Bank of Pakistan regulates banking sectorThe Institute of Chartered Accountants of Pakistan, The Institute of Chartered Accountants of Pakistan, regulator of Accounting Professionregulator of Accounting Profession

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Provisions to prevent Conflict of interest Provisions to prevent Conflict of interest in the Statutein the Statute

Provisions in the Companies Ordinance re conflict Provisions in the Companies Ordinance re conflict of interest & promote transparency include:of interest & promote transparency include:

Loans to directors (SLoans to directors (S--195)195)

CEO not to engage in competing business (SCEO not to engage in competing business (S--203)203)

Investment in (including loans to) Associated Investment in (including loans to) Associated Companies (SCompanies (S--208)208)

Disclosure of interest by directors (SDisclosure of interest by directors (S--214)214)

Interest of other Officers (SInterest of other Officers (S--215)215)

Interested directors not to vote (SInterested directors not to vote (S--216)216)

Declaring a director to be lacking fiduciary behavior (SDeclaring a director to be lacking fiduciary behavior (S--217)217)

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Provisions to prevent Conflict of interest Provisions to prevent Conflict of interest in the Statutein the Statute

Disclosure to members of directorDisclosure to members of director’’s interest in contracts s interest in contracts appointing CEO, Secretary etc. (Sappointing CEO, Secretary etc. (S--218)218)Register of contracts, arrangements and appointments in Register of contracts, arrangements and appointments in which directors are interested (S219)which directors are interested (S219)Register of directors shareholding (S220)Register of directors shareholding (S220)Disclosure by directors of their shareholding (SDisclosure by directors of their shareholding (S--221)221)Submission of statements of beneficial ownership (SSubmission of statements of beneficial ownership (S--222)222)Prohibition on short selling (S223)Prohibition on short selling (S223)Trading by directors, CEO, officers & principal Trading by directors, CEO, officers & principal shareholders (Sshareholders (S--224)224)EmployeeEmployee’’s Provident Fund (Ss Provident Fund (S--227)227)

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Accounts & DisclosureAccounts & DisclosureAll companies reqred to maintain proper books of account (S-230)

Finl Statements prepared in line with applicable IFRS, and mandatory requirements of the Ordinance. (233, 234).

Accounting Framework- All IFRSs except IFRS-1, IFRS 4.

On the whole, the accounting & reporting framework considered in line with International Best Practices.

ICAP has adopted all International Standards on Auditing to enable audit in line with int. best practices

Enforcement of IFRSs and disclosure requirements by listed companies & Banks considered effective:

Effective monitoring by SECP (nearly 25 companies auditors penalized & 100s of enforcement actions)

Effective disciplinary process (severe penalties, including removal from membership imposed)

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SECP CodeSECP CodeDrafted by Drafted by ICAPICAP’’ss Committee.Committee.Enforced by SECP through listing rules.Enforced by SECP through listing rules.Applicable to listed entities & all banks & Applicable to listed entities & all banks & DFIsDFIs..Key requirements include:Key requirements include:

CompositionComposition-- at least 25% nonat least 25% non--executive directors and at least one executive directors and at least one independent directorindependent directorDirector not to serve on boards of more than ten listed companieDirector not to serve on boards of more than ten listed companies, s, must be a tax payer, and should not be a defaulter of loans.must be a tax payer, and should not be a defaulter of loans.Responsibilities of chairman & CEO to be defined.Responsibilities of chairman & CEO to be defined.Boards to approve mission, vision, strategy, statement of ethicsBoards to approve mission, vision, strategy, statement of ethicsand major policies. (statement of ethics required to be signed and major policies. (statement of ethics required to be signed annually by all board members & employees.annually by all board members & employees.Boards required to exercise certain powers, approve key policy Boards required to exercise certain powers, approve key policy framework and issue certain statements.framework and issue certain statements.Certification of fin. Stats. By CFO & CEO before their approval Certification of fin. Stats. By CFO & CEO before their approval by by the audit committee & the board.the audit committee & the board.

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MYASCO

SECP CodeSECP Code

Board to establish sound system of internal control and issue a Board to establish sound system of internal control and issue a statement on the same. statement on the same.

Statement of EthicsStatement of Ethics-- annual communication & confirmationannual communication & confirmation

Significant issues/matters to be placed for decision of the BoarSignificant issues/matters to be placed for decision of the Board.d.

Audit committee Audit committee –– composition, TOR, Meetings.composition, TOR, Meetings.

Requirement to set up an internal audit function.Requirement to set up an internal audit function.

External auditors. (Rotation, restriction on nonExternal auditors. (Rotation, restriction on non--audit services, quality audit services, quality control, compliance with IFAC ethical guidance etc.)control, compliance with IFAC ethical guidance etc.)

Appointment of CFO, Company Secretary & head of internal audit aAppointment of CFO, Company Secretary & head of internal audit and nd their terms to be approved by the Board. their terms to be approved by the Board.

CFO & Company Secretary : removal only with the approval of the CFO & Company Secretary : removal only with the approval of the board.board.

CFO & Company secretary to attend board meetings.CFO & Company secretary to attend board meetings.

Board must ensure true & fairness of financial statements, and gBoard must ensure true & fairness of financial statements, and give ive certain statements (going concern, related partiescertain statements (going concern, related parties

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Key issues in PakistanKey issues in PakistanRelated party loansRelated party loans

Section 208 Section 208 –– related party financing / loansrelated party financing / loansMonitoring & enforcement by SECP has significantly controlled thMonitoring & enforcement by SECP has significantly controlled this is matter.matter.

Financial ReportingFinancial ReportingReasonable success achieved as far as listed companies financialReasonable success achieved as far as listed companies financialreporting and disclosure is concerned.reporting and disclosure is concerned.SECPSECP’’ss monitoring of the financial reporting & monitoring of the financial reporting & ICAPICAP’’ss quality quality assurance review, oversight of the audit and disciplinary procesassurance review, oversight of the audit and disciplinary process s has resulted improved compliance.has resulted improved compliance.

Conflict of interest related frauds in the Corporate Sector Conflict of interest related frauds in the Corporate Sector (such as awarding contracts to favorites, kick backs, double (such as awarding contracts to favorites, kick backs, double booking keeping, relating party transactions not at armbooking keeping, relating party transactions not at arm’’s s length etc.) are still pervasive.length etc.) are still pervasive.

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Comments from ROSC Report

Many stakeholders commended regulators’ role during recent years for improving the quality of financial reporting. A majority of the interviewed stakeholders praised the initiatives undertaken by the SECP, SBP and ICAP geared toward improving the quality of financial reporting in Pakistan. Stakeholders viewed that mandatory application of IFRS, monitoring and enforcement of standards and introduction of QCR were important steps toward establishing a sound corporate financial reporting regime.

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Way forwardWay forwardFraud Reporting ProceduresFraud Reporting Procedures

Establish hot lines Establish hot lines Appoint an Official Responsible to receive / attend to all Appoint an Official Responsible to receive / attend to all complaints, for which proper log should be maintained.complaints, for which proper log should be maintained.Protection / encourage whistle blowing / anonymous Protection / encourage whistle blowing / anonymous complaintscomplaints

AntiAnti--Fraud Programs and Controls should be Fraud Programs and Controls should be establishedestablished

Creating a culture of honesty and high ethicsEvaluating Anti-Fraud Processes and ControlsDeveloping an appropriate oversight process

Survey & Research is required in the emerging Survey & Research is required in the emerging markets to see the impact of Fraud on the markets to see the impact of Fraud on the Economy.Economy.

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Creating a culture of honesty and high ethics

Setting tone at the topSetting tone at the topCreating a Positive Workplace EnvironmentCreating a Positive Workplace EnvironmentHiring and Promoting (HR)Hiring and Promoting (HR)Training Training (on ethical values/fraud reporting)(on ethical values/fraud reporting)

Confirmation Confirmation (on code/core values)(on code/core values)

Discipline Discipline (all wrong doing is severely punished)(all wrong doing is severely punished)

Zero Tolerance for wrong doingZero Tolerance for wrong doing

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Tone at the topTone at the top

Directors and officers set the Directors and officers set the ““tone at the toptone at the top”” for ethical for ethical behavior within any organization. behavior within any organization. Research in moral development strongly suggests that Research in moral development strongly suggests that honesty can best be reinforced when a proper example is honesty can best be reinforced when a proper example is setset——sometimes referred to as the tone at the top. sometimes referred to as the tone at the top. The management of an entity cannot act one way and The management of an entity cannot act one way and expect others in the entity to behave differently. expect others in the entity to behave differently. Management must show employees through its words Management must show employees through its words and actions that dishonest or unethical behavior will not and actions that dishonest or unethical behavior will not be tolerated.be tolerated.

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Creating a Positive Workplace Creating a Positive Workplace EnvironmentEnvironment

Wrongdoing occurs less frequently when employees have Wrongdoing occurs less frequently when employees have positive feelings about an entity than when they feel abused, positive feelings about an entity than when they feel abused, threatened, or ignored.threatened, or ignored.Factors that increase the risk of fraud include:Factors that increase the risk of fraud include:

Top management does not seem to care or reward Top management does not seem to care or reward appropriate behavior.appropriate behavior.Negative feedback / lack of recognition for job performanceNegative feedback / lack of recognition for job performancePerceived inequities in the organizationPerceived inequities in the organizationAutocratic rather than participative managementAutocratic rather than participative managementLow organizational loyalty or feelings of ownershipLow organizational loyalty or feelings of ownershipUnreasonable budget expectations or other financial targetsUnreasonable budget expectations or other financial targetsLessLess--thanthan--competitive compensation / low salaries.competitive compensation / low salaries.Poor training and promotion opportunitiesPoor training and promotion opportunitiesPoor communication practices or methods.Poor communication practices or methods.

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Evaluating Anti-Fraud Processes and Controls

Identifying & Measuring Fraud Identifying & Measuring Fraud RisksRisksMitigating Fraud RisksMitigating Fraud RisksImplementing and Monitoring Implementing and Monitoring Appropriate Internal ControlsAppropriate Internal Controls

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• Set proper tone at the top• Establish code of conduct/ethics

•Controls gap analysis•Link fraud risks to mitigating control activities

•Communicate information to support antifraud programs and controls throughout the entity

• Monitor effectiveness of antifraud programs and controls (including management’s testing & evaluation under 404)

• Identify fraud risk factors, fraud risks and fraud schemes

PerformingPerformingFraud RiskFraud Risk

AssessmentsAssessments

Creating a Creating a ControlControl

Environment Environment around Fraudaround Fraud

Designing andDesigning andImplementingImplementing

AntifraudAntifraudControlControl

ActivitiesActivities

SharingSharingInformation andInformation andCommunicationCommunication

MonitoringMonitoringActivitiesActivities

ICFR

What Are Antifraud Programs and Controls?What Are Antifraud Programs and Controls?

AFPC

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Way forwardWay forwardFinally, a fraud awareness campaign is required Finally, a fraud awareness campaign is required among public to fight fraudamong public to fight fraud--

Be Alert, Fraud Exists : Do not be Be Alert, Fraud Exists : Do not be victim !victim !

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?Thank you