Frauds and Corporate Governance

Corporate Governance is doing the right things, at the right time, for the right reasons, and in the right manner.

Why is Corporate Governance Needed?

  1. To ensure that the company is run in a lawful and ethical manner.
  2. To make sure that there is transparency in the business processes.
  3. To ensure the independent functioning of the operations.
  4. To maintain the accountability of the Board and the management towards the stakeholders of the company.
  5. To ensure fair treatment of all the shareholders and other stakeholders.
  6. To PREVENT FRAUDS

As mentioned above, among the significant reasons necessitating Corporate Governance, is that it helps in preventing frauds in the organisation. Now the question arises, What all can one call a FRAUD?

What is fraud?

Fraud is an activity that causes unlawful gain/ loss to any person/ organisation. Fraud can take many forms but can be broken down broadly into three major categories, asset misappropriation, corruption and accounting fraud.

Why do Frauds happen?

In most of the organisations, frauds happen due to weakness in the systems/ processes of an organisation.

There are three drivers of fraudulent behaviour :

  • Pressure/Incentives to commit fraud
  • Knowledge of weakness in the checks and balances which allows the perpetrator to commit fraud and escape detection.
  • Rationalisation of fraudulent actions.

The weakness of the systems/ processes of an organisation has four causes and these generally co-exist.

First, the members of the Board - the directors on the board are not as independent as they seem to be or claim to be.

Second, the audit committee is either absent, or does not perform its duties. The reason for this is a poorly composed committee due to which their independence and oversight abilities are compromised.

Third, the processes established by the management, and concurred in by the internal auditor, are inadequate, and fail to detect the fraud at the preliminary stage.

Fourth, the top management of the organisation exerts undue influence over the company’s assets and finances regardless of how much or how little equity they own.

Let us understand this with a few examples.

DHFL’s Fraud:

A fraud of Rs 3,688 crores has been reported recently by a state-owned bank. It has said that DHFL allegedly siphoned off Rs 31,000 crore out of total bank loans worth Rs 97,000 crore through several layers of shell companies.

Religare Enterprises’ Fraud:

As per Enforcement Directorate’s allegations, Religare Enterprises’ promoters,, along with co-accused, have laundered a fund of Rs. 21,000 crores using 19 shell companies.

In both cases, the fraud happened because of two reasons:

  1. Divergence of money, which was done through shell companies.
  2. Lack of supervision by the Board and its respective committees.

Had it been that the issue was flagged on time by the relevant Board-level committee(s) or the Board, the fraud could have been prevented.

What is the need of the hour?

On the basis of the frauds which we came across recently at the corporate level, here are a few checkpoints that can be taken care of :

  1. Check for an effective preventive mechanism within the system. If absent, the internal auditor can set up the mechanism, and regular internal audits should be performed in order to have a check on the processes within the organisation. This should a continuing process and should merit special attention during the annual evaluation.
  2. The audit committee should be strong and independent. Regular checks on the committee should be there to ensure the quality of the audit.
  3. An external audit firm could also be appointed for an effective governance audit.
  4. The management committees should look into suspicious activities within the organisation.
  5. The organisation should adopt a proactive/ preventive approach instead of addressing fraud after it happens.

We should keep in mind that any fraud preventive mechanism starts from the Board. It is the Board which should ensure that committees and processes are in place.

BUT setting up committees is not enough, the Board should have an oversight on the functioning of the committees too to prevent any kind of lethargy creeping in.

All that needs to be done is creating a culture of doing the right things the right way. The tone at the top matters.