Four Fundamentals to Protect Your Foreign Operations

October 26, 2012

 

With so much focus on the BRICS countries (Brazil, Russia, India, China and South Africa) and other emerging markets, we see a precarious assumption pervading the business landscape. It goes something like this:

If you want to do business properly in emerging markets, risk is a challenge and due diligence is a must; but we’re operating only (or primarily) in mature markets, so we’re on terra firma.

Well, actually, no. Just because a market is developed doesn’t mean it’s safe.

Effective leaders know they need to be vigilant in high-risk, high-growth markets; they shouldn’t let their guard down by slipping into complacency in mature markets.

In each of the cases presented here, companies with overseas operations learned difficult lessons they likely could have learned of and corrected in more proactive and far less costly and damaging ways. Keep in mind that these real-life events took place not on the distant shores of fledgling markets, but in mature markets. A thorough understanding of your foreign operations, the local risks and how you can mitigate them can make the world a less formidable, more hospitable place in which to conduct business.

1. Know your rights and their limits before you invest.

A sophisticated investment company was a minority shareholder in an overseas technology company that was widely viewed as an innovator. Although the technology company hadn’t paid dividends, it had demonstrated solid, consistent growth and the stock had performed well.

The investment company was shocked when its investment was raided by the local securities regulator, which seized the company’s business records and computers. The stock was suspended from trading and the securities regulator eventually alleged that 90% of the tech company’s revenues were fictitious. Numerous corporate executives were charged with fraud.

As a matter of course, the tech company declared bankruptcy and a liquidator was appointed. In addition to understanding how its funds were used, the investment company wanted to know whether its in-country representative was complicit in the fraud. As an equity holder, however, the investor had little power to influence bankruptcy proceedings and the securities regulator was unwilling to provide any information about its investigation. The investor gave up, eventually liquidating its remaining investments in the country.

The take-away

While no one invests with the intention of failing, you should at least obtain a high-level understanding of the local legal environment. Ask:

  • Are guarantees and contractual protections practically enforceable?
  • What kind of recourse do you have in the event that contractual obligations aren’t met?
  • What rights do you have as a creditor/shareholder?
  • How do your rights change as a foreign entity?
  • How are your rights overseas different compared to your home country?
  • From a practical standpoint, are local courts predisposed to rule against foreign entities?

2. Recognize that without ongoing stewardship, small, immaterial subsidiaries can make a big mess.

The overseas subsidiary of a manufacturing company had a small accounting operation and felt fortunate to find a tax accountant with experience in managing consumption tax accounts. The accountant calculated the tax liability, but she also drafted the journal entries, prepared the cash requests, and made the withdrawals from the bank to present tax payments to the local tax authority.

When the subsidiary reduced imports in response to the economic slowdown, the local controller noted that the consumption tax liabilities and payments were still increasing. When he reconciled the consumption tax journal entries to the cash withdrawals, he found that the cash withdrawals were often much larger than the recorded tax payments as indicated by receipts from the tax authority.

When confronted, the tax accountant admitted to embezzling approximately $760,000 in the course of two years and revealed that she had previously stolen more than $1.2 million from a previous employer using the same scheme.

The take-away

The parent company had missed a chance to proactively mitigate the subsidiary’s risky ways. In fact, the subsidiary’s reliance on a small accounting staff with insufficient segregation of duties was exacerbated by the lack of consumption tax account knowledge among the accounting staff. Further, no one had been double-checking the tax accountant’s work.

How did the embezzler, with her shady track record, get hired in the first place? Privacy laws in the local market made it difficult to ascertain information regarding a prospective employee’s work history and experience. But for employees in positions of trust, such as those handling large amounts of cash, local firms can often provide reputation and background assessments without running afoul of the law.

3. Understand how your operations can digest local customs — in ways that might cause heartburn.

A US manufacturer had an overseas sales subsidiary that primarily sold equipment to public institutions. These sales constituted less than 2% of the company’s global sales.

The public entities’ budgets contained separate budget lines for equipment, service and repairs, and spare parts. Under local purchasing laws for public institutions, it was not permissible to spend unused funds from one budget category on other categories.

When, in a routine review of quarter-end transactions, US accounting staff analyzed a small number of the subsidiary’s transactions, they discovered a sale of equipment that had been invoiced as a combination of a discounted equipment sale and a sale of repair services.

The resulting investigation also revealed instances of equipment sales partially invoiced as spare parts. In these cases, the sales team delivered assortments of obsolete spare parts to the entities to substantiate the spare parts invoices.

The subsidiary had also booked multiple sales transactions based solely on personal notes from the heads of the institutions, indicating that the entity would pay for the goods in the next budget cycle. While this turned out to be the case, there was no formal arrangement with the entity, such as a purchase order or a sales contract, to support the revenue recognition at the time the transactions were booked.

Most of the subsidiary’s revenue for the three prior years had to be restated or re-categorized (or both).

When sales personnel were asked why they had manipulated the sales, they stated that it was required to secure sales from the public institutions. If they hadn’t done this, the entities would purchase the goods from a competitor who was willing to accommodate them.

The take-away

Business leaders need to understand how their sales channels vary from country to country and confirm that the associated risks are being managed and mitigated. In this case, the US accounting group’s monitoring activities uncovered the problematic practices, but by then, the behaviors had gone on for years and the local risks had gone unaddressed.

4. Tear down language barriers before they block your information pipeline.

A privately held US manufacturer obtained an overseas subsidiary as part of an acquisition. The subsidiary’s general manager (GM), who pre-dated the acquisition, was the only employee in the foreign office who spoke English. All reporting to US headquarters went through him.

The overseas entity generally appeared to be problem-free. US headquarters never sent its internal audit staff to check on the operation, as they would have been able to communicate only with the GM. This precluded interviews with other employees and made it tough to complete process walk-throughs and transaction testing. Further, the cost to travel to this location was much higher than traveling to other company subsidiaries.

During regular financial performance reviews, US headquarters began to notice unusual movements in inventory and inventory reserves. Headquarters posed questions to the GM, who then posed them to the local controller, before relaying the answers back to US headquarters.

Following several rounds of questions and numerous revisions to the reported figures, US headquarters undertook a formal investigation to get answers. They learned that the controller had been manipulating the inventory reserve model to achieve budgeted financial targets. The company implemented stronger formal controls over the use of the inventory model and set its sights on a bilingual controller who would report directly to US headquarters.

The take-away

A routine visit from internal audit likely would have revealed the lack of controls around use of the inventory model and the related journal entries. The inventory reserve model was also unnecessarily complex and susceptible to human error/adjustment at numerous points in the calculation process.

Yes, there’s expense associated with retaining bilingual resources to help with internal audits. But the cost of investigation in this case was many times higher. While most audit plans are justifiably based on risk assessments, entities should be subjected to rotational/periodic audits or desk reviews to confirm that reported financial and operational results are reliable.

John Stanley is a director in PwC’s Forensic Services practice and is focused on assisting clients with investigations regarding fraud, accounting and corruption matters. He has served clients on a range of issues in both mature and developing Asia-Pac countries.

Source: http://businessfinancemag.com

Posted by: www.in-tune.biz

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