Managing occupational fraud in Korea

Despite being a pervasive issue around the world, occupational fraud receives surprisingly little attention from companies doing business in Korea, including foreign-invested companies.

Given the harmonious relationships and fierce loyalty that commonly exists within the Korean workplace environment (referred to as “inhwa” in Korean), local management has a tendency to take a rose-tinted view of their own organization, easily dismissing the possibility that employees could be engaging in fraudulent activities. Accordingly, having discussions about occupational fraud can be awkward and are often viewed as being unnecessary.

Companies can also be lulled into a false sense of security regarding occupational fraud risk, assuming that existing internal controls, internal and external audits are sufficient for prevention. This can lead to passivity, especially if occupational fraud has not been a problem in the past. Unfortunately, this is precisely the type of environment where occupational fraud can flourish and go undetected for years. Moreover, the current economic environment in Korea has dramatically increased risk of occupational fraud and companies really need to be more vigilant than ever in order to avoid become victimized.

Perfect storm for occupational fraud 

Dr. Donald Cressey is credited with developing the theory of the “Fraud Triangle,” which refers to three conditions that are usually observed when fraud occurs: motive, opportunity and rationalization. A challenging economic environment has an uncanny way of bringing these conditions together to create a perfect storm for occupational fraud to take place.

Motive: decreased profitability can give rise to tremendous pressure to increase sales and reduce costs. Some companies may be having difficulty accessing credit or meeting debt covenants. Management can be desperate to find solutions, even if they are only short-term, particularly when compensation is tied to meeting performance goals. Employees who were previously concerned about raises, promotions and/or bonuses are now anxious about being downsized. There may also be personal financial pressures at play, which may include mounting credit card debt, school tuition, car payments, home loans and so on. Families trying to keep up with the Kims may find themselves living well beyond their means. Desperate times can call for desperate measures, and these types of mounting pressures can easily push an otherwise honest employee over the edge.

Opportunity: as management becomes preoccupied with improving sales and controlling costs, there is a higher likelihood that internal controls and risk management will get neglected. It is also more difficult to maintain internal controls and segregation of responsibilities in a downsized organization where fewer employees are being asked to do more.

Rationalization: attributable in part to the concept of inhwa, it is not unusual for local management to feel personally responsible for their employees. In Korea, this intimate relationship manifests in interaction at the office as well as outside the office at group outings, attendance at weddings or funerals, and so on. Interestingly, the same dynamics that create this unique organizational harmony also increase the perchance that a well-intentioned “corporate savior” will emerge that is willing to “cook the books” to prevent the loss of jobs. “The ends justify the means” axiom can also apply equally to employees that are struggling under financial distress while trying to maintain the family livelihood. There are also employees that are willing to engage in fraud simply because they can get away with it.

Prevalence of occupational fraud

Occupational fraud can generally be broken down into the following three categories: corruption, asset misappropriation and financial statement fraud.

According to Transparency International’s 2013 Corruption Perceptions Index, Korea was ranked 46th out of 177 countries and territories included in the survey. While the survey focuses on corruption in the public sector, the results can be used to make some inferences about corruption in the private sector. Despite falling within relatively close to the top quartile of results, Korea’s ranking seems conspicuously low when considering Korea’s status as a developed country with the 15th largest economy in the world.

The most common form of corruption in Korea is bribery. According to Transparency International’s Bribe Payers Survey, Korea was ranked 13th out of 28 leading economies. The survey specifically examines the likelihood of firms to engage in bribery abroad, which may also provide an indication of the proclivity to engage in bribery domestically. Again, the results seem to suggest that Korea has significant room for improvement.

While there are no reliable aggregate statistics, bribery tends to be more widespread in certain industries than others. For example, bribery in the form of illegal rebates is a significant problem in the Korean pharmaceuticals industry. The Board of Audit and Inspection of Korea reported that illegal rebates amounted to 1.1 trillion won during 2003 to 2011. Since 2007, the Fair Trade Commission has imposed over 40 billion won in fines on pharmaceutical companies doing business in Korea. It’s noteworthy to mention that fines have been imposed on domestic as well as foreign-invested pharmaceutical companies.

Asset misappropriation is by far and away the most common form of occupational fraud. Company assets potentially subject to misappropriation can include tangible assets (i.e., cash, inventory or equipment) as well as intangible assets (i.e., proprietary information). It’s also important to understand that misappropriation can be committed by management, employees, customers and/or suppliers.

There is a veritable cornucopia of asset misappropriation schemes ranging from stealing cash directly from the company vault, to elaborate forms of collusion with suppliers or customers, to selling proprietary technology to a competitor. Some of the schemes commonly observed in Korea include: misappropriation of customer payments such as an employee receiving payment from a customer but not recording a sale, fraudulent expense reports such as an employee submitting a falsified or inflated expense for reimbursement, and fraudulent disbursement of company funds such payment for fictitious goods or services.

In many cases, a scheme can go undetected for many years, particularly when the magnitude of a single instance of misappropriation is not material. Repeated over time, however, the aggregate amount of misappropriation can become substantial.

Financial statement fraud

Financial statement fraud refers to the deliberate misstatement of any element of an income statement or balance sheet. Common forms of financial statement fraud are the overstatement of revenues/assets or the understatement of expenses/liabilities. It is also noteworthy to mention that financial statement fraud usually involves the most senior levels of management. There has been a number of high profile accounting frauds that have taken place in Korea over the last several years. While cases involving large Korean corporations make headlines given the magnitude of the fraud committed, there is less awareness about financial statement fraud that occurs at Korean subsidiaries of foreign-invested companies since this information is generally kept confidential. Our practical experience suggests that financial statement fraud at foreign-invested companies has similar rates of occurrence as domestic companies but on a smaller scale. In most cases, the financial misstatement will have a material impact on the financial results of the local operation and, in some cases, will actually require disclosure in the consolidated financial statements.

Best practices for managing fraud risk

While it is practically impossible to fully eliminate the occurrence of fraud, implementing certain preventative measures can go a long way in terms of mitigating fraud risk. The most effective way to manage fraud risk is by establishing a comprehensive anti-fraud program that is tailored to specifically address a company’s unique circumstances and requirements. A robust approach for developing an effective anti-fraud program is comprised of the following three phases: risk assessment, prevention and deterrence, monitoring and detection.

In “The Art of War,” Sun Tzu advocates knowing your enemy. Similarly, fraud risk can only be effectively managed after recognizing the potential for fraud to occur and identifying risk exposures. A proper risk assessment should include the following: review of a company’s key business activities, functions, organizational structure, existing internal procedures and controls, identification of potential fraud risk including susceptibility to specific fraud schemes and assessment of likelihood of fraud occurrence, potential consequences and resulting impact.

The risk assessment should reflect the company’s management structure, internal policies as well as business environment. In addition, it should also consider the unique attributes of the geographic market(s) in which the company operates and/or transacts business (which may extend beyond Korea) as well as the unique attributes of the industry in which it competes, including local business practices. As a company’s risk exposures will be subject to change along with changes in business operations or environment, risk assessments should be performed on a regular basis.

Finally, one of the major benefits of performing a risk assessment is that it helps send a message throughout the organization that management is serious about fraud prevention.

After completing a fraud risk assessment, it is necessary to establish an appropriate level of risk tolerance. Since it is impossible to completely eliminate fraud, it is well advised to pick your battles. The level of risk tolerance set will serve as the basis for developing and implementing preventative measures (as well as future monitoring activities).

Prevention really begins with the establishment of proper and effective internal controls. Accordingly, any weaknesses in internal controls identified through risk assessment should be remediated. Some commonly identified weaknesses include: segregation of duties (no separation of authorization and recordkeeping), authorizations (lack of formal approval procedures for critical controls), IT security (improper use of IDs and passwords and the ability of unauthorized personnel to access information) and record retention (lack of proper documentation substantiating transactions).

Beyond implementing strong internal controls, there are various other mechanisms that companies can use to help deter fraud. Having a formal code of conduct can help foster an environment of ethical behavior within the organization. The code of conduct should clearly establish values/principles and expectations/aspirations. The code of conduct should also be highly visible and reinforced and referenced on a regular basis.

Employee education programs can also help deter fraud by raising awareness. The most successful education programs will help clarify what constitutes fraudulent misconduct against the organization, review company policies against misconduct and provide a forum for discussion. These types of training should be held on a periodic basis.

Despite best efforts, it is virtually impossible to stop an employee who is absolutely intent on committing fraud. For this reason, it is advisable to monitor employee compliance on a regular basis. IT systems can be set up to identify red flags, such as unusual or irregular transactions. It may also be helpful to conduct surprise fraud audits.

Many companies utilize a whistleblower hotline which can provide a means for tipping off potential fraudulent activities. The most effective hotlines are available 24/7/365, multilingual and ensure confidentiality. Hotlines should be made available to employees, suppliers/vendors and customers.

Given the numerous potential regulatory implications of an act of fraud, it is imperative to contact legal counsel (in-house or external) to determine appropriate action once fraud is detected. In some cases, forensic accountants will be requested to investigate and verify the fraudulent misconduct.

Costs of occupational fraud

The overall cost of occupational fraud can be significant. In addition to the monetary amount lost as a result of the fraud itself, the aftermath of fraud can also have considerable cost in terms of collateral damage to business reputation as well as a decline in employee morale. The occurrence of fraud may also attract the attention of regulatory bodies and can lead to the imposition of fines as well as lawsuits.

Unfortunately, there is no “magic bullet” or “one-size-fits-all” solution to managing fraud. Organizations need take a holistic approach that is tailored to specific needs. Effective implementation also requires creating a strong culture of ethical behavior which begins with the tone at the top and is reinforced on a regular basis.

By Henry An
The Korea Times