ACFE Cookbook

Using one fraud to hide another



In each of the cases I've covered in recent columns, the only fraud involved cooking the books. But in other cases, fraudsters commit financial statement fraud as the secondary act to conceal the primary frauds. When a company pays illegal bribes it normally hides these bribes somewhere in its financial statements by misclassifying the expenditures in one of the reported categories of legitimate business operating expenses. In this column, I'll explore a few recent cases in which the U.S. Securities and Exchange Commission (SEC) took enforcement action against companies for violating the Foreign Corrupt Practices Act (FCPA) in connection with paying bribes to government officials outside the U.S. to further their business interests.

FCPA primer

The FCPA, which Congress passed in 1977, criminalized bribes that U.S. companies and individuals pay to foreign government officials. The U.S. Department of Justice investigates allegations of illegal payments of bribes. Another part of the FCPA requires that a public company maintain books and records that accurately reflect the transactions of the company, i.e. so bribes aren't buried someplace in the company's financial statements. The SEC investigates this provision of the FCPA, along with a related part requiring adequate internal controls.

Ding dong, Avon calling

The Avon Products Inc. case is an excellent example of how a company can hide bribes in the financial statements. Avon recently agreed to pay $135 million to settle charges that an affiliate paid bribes to Chinese government officials. The SEC could investigate because the Chinese affiliate's financial statements were included in the consolidated statements of the U.S.-based parent.

According to the SEC complaint, the Avon affiliate paid approximately $8 million in bribes to Chinese government officials between 2004 and 2008, which enabled the company to earn about $53 million in profits. (This is the disgorgement amount that Avon agreed to.)

One of the many reasons Avon bribed Chinese officials was so they would award Avon the country's first direct-selling business license in March 2006; none of the company's competitors received licenses before December 2006.

Avon also paid bribes to enable a "zero penalty policy" — as the company called it — to reduce or eliminate potential fines against the company and to prevent negative media coverage.

Avon bribed Chinese officials in the following ways, each with obvious links where Avon would classify the bribes in the financial statements:

  1. Avon employees incurred 9,600 separate meal and entertainment expenses totaling $1.65 million for government officials.
  2. Avon provided at least $1.7 million worth of its products to government officials, plus another $400,000 in gifts, including tickets to the China Open tennis tournament.
  3. Avon employees paid for approximately $1 million in travel for Chinese officials. During several of these purported business trips little to no business took place. (In one instance, Avon spent $328,000 for three to five days of travel for more than 200 government officials to visit Avon's Guangzhou property; they visited the facility for only a half day and toured resort areas in southern China for the rest of the trip.)
  4. Avon paid $1.5 million in bribes to vendors and consultants — an easy way to hide bribes — with the understanding that these parties would use the funds to pay government officials.

Numerous smaller categories make up the remainder of how Avon provided the $8 million to Chinese officials and where it likely recorded the bribes in its financial statements.

The U.S. government learned of the fraud when Avon, after some internal discord, eventually reported the violations to the SEC. The company reportedly cooperated significantly with authorities during the investigation. Had it not done this, the $135 million penalty could have been much higher.

Tires, chemicals and scientific instruments

Unfortunately, the Avon case isn't the only recent case in which the SEC went after a company for improper reporting of — and poor internal controls over — bribes.

Goodyear. A wholly owned subsidiary of The Goodyear Tire & Rubber Company paid $1.4 million in bribes to government officials in Angola from 2007 to 2011. The subsidiary hid the bribes by falsely marking up the cost of tires with added phony freight and customs clearing costs to its invoice prices, which made it appear as though it was passing these costs to customers. As the subsidiary sold tires, it posted the phony costs to a liability account — because customers weren't paying for them — which would then be reduced as it paid bribes to officials. In the end, the subsidiary classified bribes as freight charges in the income statement.

Bio-Rad. From 2005 to 2009, a Singapore-based affiliate of Bio-Rad Laboratories Inc. paid $2.2 million in bribes to government officials in Vietnam through agents or distributors (i.e., Bio-Rad didn't directly pay any of the bribes). Bio-Rad classified the bribes as commissions, advertising fees or training fees depending on the type of service the agent or distributor purportedly provided.

Bruker. Four Chinese affiliates of Bruker Corporation paid $231,000 in bribes from 2005 to 2011 to employees of state-owned entities (SOEs) in China. All four affiliates provided travel for Chinese officials. These leisure trips in Norway, the U.S., Sweden, France, Germany, Switzerland and Italy typically followed legitimate business meetings.

Also, one affiliate provided bribes under "research cooperation" ventures and "collaboration" agreements. Under the 12 suspicious agreements, the SOEs supposedly were to provide research on Bruker products. But Bruker didn't specify the deliverables in the agreements and the SOEs didn't deliver any services. Sometimes, the company entered into these agreements directly with Chinese government officials rather than SOEs.

The bribes enabled Bruker to generate profits of more than $1.7 million. In all cases, the company improperly classified the bribes as legitimate business and marketing expenses in its financial statements.

What about fixing the financials?

Interestingly, companies seldom restate financial statements after they discover hidden bribes. Normally, when an organization identifies financial statement fraud — at least if it's a public company — it restates the affected statements to accurately reflect the company's transactions and activities. However, you would be hard pressed to find a restatement to accurately report the payment of bribes. In fact, about the only bribery cases in which companies have restated the financials are those in which it also found other frauds.

So, why doesn't the SEC require companies to restate incorrect financial statements? I have a few theories:

  1. Materiality: As bad as bribery sounds, the effect of the misclassification of these bribes in the financial statements is rarely material to the statements. Even in the Avon case, $8 million of bribes over five fiscal years would be extremely immaterial to the company's consolidated financial statements.
  2. Reclassification: In almost every bribery case, the effect of correcting the financial statements would amount to nothing more than a reclassification from one category of expense to another. The misclassification rarely impacts profits or the overall financial condition of the company.
  3. Settlement: A much more material impact on a company's financial statements occurs after a bribery investigation and a settlement, such as in the Avon case. Accordingly, authorities are normally satisfied when companies separately disclose the amount of a settlement (and, if significant, the costs incurred by the company in investigating the matter) in the period in which it occurs, which might be several years after the underlying offense.

Concealing underlying crime

In each of the cases here, the intentional misrepresentation of the financial statements was secondary to the principal crime of paying bribes. Most companies commit financial reporting frauds to misrepresent revenues, profits or the financial condition of a company. However, when organizations bribe officials, often their goal is to conceal the underlying crimes. In future columns, I'll explore some other uses of financial reporting fraud as a secondary act used to conceal other crimes.

I'm always looking for recent cases and news involving alleged financial reporting fraud around the globe. Email me your links, news or information on public reports of alleged fraud.

Gerry Zack, CFE, CPA, CIA, is a managing director in the Global Forensics practice of BDO Consulting, at which he provides fraud risk advisory and investigation services. He is also the 2015 chair of the ACFE Board of Regents and an ACFE faculty member. His email address is: gzack@bdo.com.





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Reviews
 
By prestige_rentals
Very useful information you share in this article. I think everyone must read this and know about this.
 
By Jmassey
I was expecting to read a case but this was just an article. You need to be more specific in your classifications.
 
By Jmassey
I was expecting to read a case but this was just an article. You need to be more specific in your classifications.