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Fraud Risk and Prevention in China

With multiple instances of very large-scale fraud from Chinese companies hitting the news over the past few years, 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. But…”

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. In addition, the approach that companies in China take to 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 also a point of increasing concern, as a lot of companies in China have graduated from a manufacturing focus to a model where their real business value is in their intellectual property.

One grey area of understanding fraud in China comes in the form of wielding guanxi. If you have read our articles about guanxi, you will know that Chinese will often exert their personal influence and connections to make sure a business deal goes smoothly, or to enable an opportunity that was otherwise unavailable. Sometimes one will treat a business partner to dinner to build up guanxi that can be used later to influence decisions that are not illegal, but sometimes not exactly legal either.

Fraud risk can also vary significantly with the complexity of an organization’s structure. While a trading company requires one of the most straight-forward internal control systems, organizations with a lot of marketing and those that deal with many vendors and a complex supply chain have a high risk of fraud. In fact, even with the most simplistic business model, inappropriate behavior uncovered by internal audits can be quite deep in a company.

For foreign-invested companies in China, this means increasing vigilance in strengthening internal control systems for fraud prevention.

Some experts suggest considering fraud prevention based on the “fraud triangle” – opportunity, motivation and rationalization.

Opportunity can be limited by focusing on the internal control. 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.

Motivation corner of the fraud prevention triangle can be influenced through the recruitment stage. Pre-employment screening should be done for all sensitive posts.

Rationalization is the hardest to deal with in internal control. One place to consider it, however, is with procurement staff and suppliers, who are often dealing with thin profit margins. As these are already in the “fraud potential zone,” a closer look can clarify whether procurement staffers are acting in the best interests of the company and suppliers following their original contract obligations.

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