Jfar-51930.pdf

Journal of Forensic Accounting Research Vol. 2, No. 1 2017 pp. A91–A107

American Accounting Association DOI: 10.2308/jfar-51930

A Repeat Offender of Corruption: South MunaiGas Case Study Willie Reddic Sandra W. Shelton Georgi K. Shmagel DePaul University ABSTRACT: Fraud is a serious and growing international problem, and can greatly affect a company’s performance. The current case highlights the impact that culture can have on corporate corruption through the culture of a specific organization, as well as through the broader culture of a society. In this case, Russian NorthOilService (NOS) acquired 98 percent of the shares of the near-bankrupt Kazakh drilling company, South MunaiGas (SMG) in 2007. NOS management realized that SMG’s weak financial standing was caused by corporate fraud and corruption, among other factors. Unfortunately, NOS was unable to prevent the new management team of SMG from committing fraud, despite NOS’s anti-fraud efforts after acquisition. This actual case study focuses on the accounting and other frauds perpetrated by the SMG management team and the anticorruption measures implemented by NOS. It addresses fraud, bribery, corruption, and misappropriation of assets through inappropriate procurement procedures, in a cultural environment differing substantially from U.S. corporate contexts. This case is suitable for use in auditing, corporate governance, and fraud examination courses. Keywords: fraud; corporate governance; management reorganization; internal control; international business; cultural issues.

INTRODUCTION

T

he case of South MunaiGas enhances student learning by engaging students in an interactive class discussion regarding cultural and structural factors that may lead to fraud and corruption activities in an international context. It challenges students to address fraud types, bribery, corruption, and misappropriation of assets through procurement procedures, based on a real-world situation in Kazakh and Russian companies. In contrast to other internal control cases (see Reisch 1999; Mellon and Marley 2013) that concentrate more on the auditor’s role and responsibilities, this case gives students the opportunity to step into top management’s shoes and We benefited from discussions from the editor and three anonymous reviewers. We gratefully acknowledge the financial support of the School of Accountancy and MIS at DePaul University. Editor’s note: Accepted by Charles D. Bailey. Submitted: December 2016 Accepted: September 2017 Published Online: October 2017 A91

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review the situation in all its complexity from that perspective. It exposes students to decision making in an ethically ambiguous situation, and requires them to be creative and consider multiple factors in solving a problem of corporate corruption in a real company. Similar to some previous studies (Higgins 2012; Holtzblatt and Tschakert 2014, Dutta, Caplan, and Marcinko 2014), the case immerses students in an original business and cultural environment as they examine corporate governance structures. This case builds upon prior studies by focusing on internal control weaknesses and the tone among senior management that can lead to the reoccurrence of fraud following a merger of two entities. Moreover, the case demonstrates how corporate corruption can develop and transform through time, and how poor governance structures can allow company executives to commit fraud again and again.

PART ONE Background Kazakhstan is a country in Central Asia whose territory has historically been inhabited by nomadic tribes. Kazakhstan is the ninth largest country in the world by geographic size, and its territory is larger than Western Europe by 1,052,100 square miles. However, Kazakhstan’s estimated population in 2016 was around 18 million people, compared to the European Union’s 510 million; Kazakhstan’s population density is among the lowest in the world at less than 15 people per square mile. From the mid-19th century until the early 1990s, Kazakhstan was part of the Russian Empire; the country declared independence in 1991. Despite 150 years of history as a part of the Russian commonwealth, the Kazakh people preserved their customs and rich nomadic culture. Patriarchy and blood ties are of significant importance within the Kazakh community. Most inhabitants of Kazakhstan proclaim that family is among the most important values in life. Strong respect for elders and power are also a cornerstone of Kazakh society. Citizens demonstrate respect for power by consistently electing the country’s current President, Nursultan Nazarbayev, by large margins (more than 90 percent of the vote). Kazakhstan is a fast-growing economy and conducts business in the solid hydrocarbon industry. Over the last decade, Kazakhstan’s economy grew at an average of 8 percent per year before a slowdown in 2014.1 International financial institutions describe corruption as one of the biggest problems in doing business in the country. Prior to 2007, the World Bank listed Kazakhstan as a corruption hotspot, along with Angola, Bolivia, Kenya, Libya, Pakistan, and others.2 In 2016 it was ranked at a poor 131 out of 176 countries based on the Transparency International Corruption Perception Index (e.g., http://www.transparency.org), which equates to a score of 29 out of 100 (see Table 1). In the 1990s and early 2000s, the economy in Kazakhstan was unstable and the Kazakhstan Stock Exchange (KASE) was volatile. In this context, shares of one of the oldest Kazakh oil and gas (O&G) drilling companies, South MunaiGas (SMG), changed ownership regularly. The company had been established in 1958 in Southern Kazakhstan (see Figure 1), but in 1994, President and CEO of SMG, Rahim Kabaev, purchased enough shares to gain complete control over the company. He had been CEO for ten years prior to his 1994 purchase. With ongoing changes in the ownership of other shares, R. Kabaev was able to solidify his authority to make 1 2

International Monetary Fund (IMF 2013). Stodghill (2006).

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2009

2010

b

a

133rd/28 (Comoros, Guyana, Honduras, Iran, Russia) 126th/29 (Azerbaijan, Gambia, Honduras, Nepal, Pakistan, Togo) 131st/29 (Iran, Nepal, Russia, Ukraine)

65th/30 (Burkina Faso, Zimbabwe) 107th/26 (Belarus, Eritrea, Honduras, Nicaragua, Palestine, Ukraine, Vietnam, Zambia, Zimbabwe) 150th/21 (Azebaijan, Belarus, Congo Republic, Cote d’Ivorie, Ecuador, Kenya, Kyrgyzstan, Liberia, Sierra Leone, Tajikistan) 145th/22 (Timor-Leste) 120th/27 (Armenia, Bolivia, Ethiopia, Mongolia, Vietnam) 105th/29 (Algeria, Argentina, Moldova, Senegal)

Kazakhstan

Russia

147th/21 (Bangladesh, Kenya, Syria) 146th/22 (Cameroon, Ecuador, Kenya, Sierra Leone, Timor-Leste, Ukraine, Zimbabwe) 154th/21 (Cambodia, Central African Republic, Comoros, Congo-Brazzaville, GuineaBissau, Kenya, Laos, Papua New Guinea, Tajikistan) 133rd/28 (Comoros, Guyana, Honduras, Iran, Kazakhstan) 136th/27 (Cameroon, Iran, Kyrgyzstan, Lebanon, Nigeria) 131st/29 (Iran, Kazakhstan, Nepal, Ukraine)

143rd/23 (Gambia, Indonesia, Togo)

82nd/21 (Kenya) 126th/24 (Albania, Niger, Sierra Leone)

CPI Rank/Score (Alongside)b

17th/74 (Barbados, Hong Kong, Ireland) 18th/74

19th/73

22nd/71 (Belgium)

18th/73 (Belgium, Japan) 19th/75

20th/72

17th/76

14th/78

U.S.

CPI Score relates to perceptions of the degree of corruption as seen by business people and country analysts, and ranges between 100 (highly clean) and 0 (highly corrupt). For example, Kazakhstan in 2016 had a CPI score of 29 out of 100, which is perceived as a highly corrupt country. In addition, Kazakhstan was ranked 131 out of 176 countries surveyed. The Transparency International Corruption Perception Index website is: http://www.transparency.org/. These countries were tied on the Corruption Perception Index.

176

180

2008

2016

180

2007

174

179

2005

2014

158

2000

174

90

Year

2012

No. of Countries Researched

Corruption Perception Index (CPI) Dynamics for Kazakhstan, Russia, and the U.S.a

TABLE 1 Reddic, Shelton, and Shmagel A93

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FIGURE 1 Map of South MunaiGas Business Activities

Adapted from: https://www.google.com/search?q¼kazakhstanþmap&rlz¼1C1GGRV_enUS752CA752&tbm¼isch& source¼iu&ictx¼1&fir¼zis6PAFvZWCRGM%253A%252CGjPbgwOpzE0PVM%252C_&usg¼__4iPAHL8zUo002_ 6nxVpQx6Rh0Rs%3D&sa¼X&ved¼0ahUKEwjhhJmBnYXYAhUGwBQKHcIqCD8Q9QEIMTAD#imgrc¼zis6PAFvZWCRGM

decisions that would increase his personal wealth. R. Kabaev made several decisions during his tenure at SMG that resulted in customer order decreases, equipment obsolescence, lower net income, and the hiring of unqualified personnel. Consequently, toward the end of 2006, SMG was headed toward bankruptcy. Russian-based NorthOilService (NOS) acquired SMG in 2007, with the intention of expanding into the Kazakh market and providing a full array of services to existing SMG customers. Due diligence performed by one of the Big 4 accounting firms prior to the SMG acquisition revealed significant cost inefficiencies in SMG’s operations, weaknesses in management, and inaccuracies in accounting reporting. Although the audit suggested the possibility of mismanagement, the type and extent of that mismanagement were unclear. NOS management still considered the deal profitable and although SMG was headed toward bankruptcy, it still had a favorable reputation in Kazakhstan as the oldest and best-known drilling contractor in the country, and had a strong customer base. NOS’s strategic plan for SMG called for significant improvements and investments that included purchasing new drilling rigs, increasing the number of drilling teams, and expanding SMG’s customer base geographically. Since NOS did not have prior knowledge of drilling Journal of Forensic Accounting Research 2017

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operations and experience in working in Kazakhstan’s business environment, NOS planned to retain members of SMG’s existing management team, provide new members from NOS, and reorganize responsibilities. In light of Kazakh traditional respect for authorities, and because concerns raised by the pre-acquisition audit struck NOS management as minimal, NOS decided to retain the President/CEO R. Kabaev and his executive team, which had solid connections with Kazakh government officials and with the Kazakh business community, as described below.

NEW MANAGEMENT TEAM STRUCTURE AND ROLES The new management team consisted of existing NOS professionals and experienced drilling managers who were hired specifically for the SMG project, in addition to SMG’s long-time President. The team’s core consisted of: 

Andrey Sernev, NOS Drilling Operations Project Lead and member of the Board of Directors for SMG * Hired by NOS for the project, A. Sernev was responsible for establishing NOS drilling and for optimizing SMG’s development. A. Sernev reported to the CEO of NOS.  Rakhim Kabaev, President (CEO) of SMG, member of the Board of Directors for SMG * R. Kabaev retained his position after NOS acquisition. Although the new Board gave formal power of attorney to Vladimir Semenov, R. Kabaev operated in practice as a CEO with full power to take independent action. R. Kabaev reported directly to the Board of directors for SMG.  Vladimir Semenov, First Vice-President (VP) and Head of Engineering for SMG * Hired by NOS, V. Semenov was responsible for SMG drilling operations. Although he had a full power of attorney for SMG, he formally reported to the President/CEO of SMG, R. Kabaev.  Natalie Semenov, Vice-President of Economics and Finance for SMG * Hired by NOS, N. Semenov was responsible for all financial and accounting issues at SMG. In addition, she was the wife of V. Semenov and reported to the President/CEO of SMG, R. Kabaev. A. Sernev and both Semenovs were highly experienced in drilling operations and were hired by NOS specifically for the SMG project. They had been working together for more than ten years and had participated in many successful O&G drilling projects in northern Russia. They brought with them several team members with whom they had worked previously: key engineers, mechanics, and procurement specialists. This management team concentrated directly on the reorganization of SMG’s production practices and on the $30 million investment program that NOS initiated to increase profitability for SMG. Although the pre-acquisition audit raised flags about SMG’s accounting practices, it was through the work of the new management team that NOS discovered widespread corruption at SMG. NOS’s legal counsel led the investigation of these practices of corruption, joined by two new candidates who were brought in to handle security and procurement; the three came to form an unofficial anticorruption team: 

Yuri Schmidt, Lawyer of NOS’s legal department * Y. Schmidt was responsible for the procedural guidelines of NOS’s standard corporate policies and for all SMG internal legal issues. To ensure his independence and impartiality, he reported directly to the Deputy Director on Legal and Organizational Issues (LOI) for NOS.  Anton Petrov, Vice-President of General Affairs for SMG Journal of Forensic Accounting Research 2017

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FIGURE 2 Corporate Structure for South MunaiGas February 2008

A. Petrov was an experienced security officer who was hired by NOS to oversee production support and security. He reported to the First VP, V. Semenov.  Roman Borisov, Deputy Head of Procurement for SMG * Hired for the project by NOS, R. Borisov was responsible for procurement within SMG. He reported to the VP of General Affairs, A. Petrov. *

In order to optimize SMG’s management system, NOS issued a new corporate structure for SMG in February 2008 (see Figure 2). SMG’s spending for production support activities, such as transport, maintenance, procurement, and food supply, had been enormously high. At the same time, the quality of these services was poor and the majority of these operations were nontransparent. Under the new structure, all production support divisions such as transportation, procurement, and social services were subordinated to the new VP of General Affairs. Journal of Forensic Accounting Research 2017

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FRAUD IN SMG BEFORE THE NOS ACQUISITION The new management team discovered widespread corruption in SMG. For example, company positions were awarded based on loyalty to top management, and employees were allowed to use their position for personal enrichment by siphoning off company assets, taking kickbacks, etc. Employees were required to pay a percentage of any proceeds from fraudulent operations to supervisors or directly to the President, who continued these practices even after the new management team was implemented. SMG’s workforce was made up of individuals who had little to no education, received low pay, and had a high dependency on their employment, due to the overall high unemployment rate in Kazakhstan. In this context, nepotism is widespread, as are practices deemed ‘‘corrupt’’ by international standards; bribes, personal use of company assets, and even theft of company materials are standard practice and are judged by many Kazakhs to be entrepreneurial rather than criminal.3 In the context of Kazakhstan’s post-Soviet capitalist transition, many Kazakhs have deemed it necessary to manage for oneself in the face of growing corporate gain. While companies in Western Europe and the United States are not without their own practices of corruption, bribes and fraud exist in a different cultural environment in Kazakhstan. Analysts should not interpret differences as a reflection of Western cultural superiority, but should aim to understand the structures that explain such differences. SMG’s pre-NOS corporate governance was inefficient and chaotic. It was comprised of controversial and questionable legal orders that were made by the President. The official pre-NOS corporate structure did not match the actual internal hierarchy, which was mostly based on personal relationships. Employees’ responsibilities were often different from those that were stated in their original job descriptions. The internal corporate workflow was not regulated by management. While documentation practices in Kazakhstan do not necessarily follow American or other Western cultural traditions of codification, in general, SMG’s practices were an extreme case. Significant percentages of transactions were made without having appropriate signed contracts. Government certificates, contracts, production reports, and other corporate documents did not receive appropriate revision and systematization in archives. Some of these documents that were drafted had mistakes or were outdated, damaged, or even missing (e.g., certificates of corporate registration, prospectus of share issue, certificates for land and building ownership). Poor internal accounting within SMG produced unreliable financial statements. For example, SMG financial statements contained errors and direct inconsistencies. Values in the financial statements did not match values in source documents. Some of the values were simply put into the financial statements and did not correspond to other numbers in the document. Bribes were widespread at SMG. Employees paid bribes to Human Resources officers for a variety of reasons such as getting a job, getting hired into another position in the company, and getting vacation on certain dates. Supervisors and managers also hired fictitious employees, whose names were registered in the HR and accounting systems. The supervisors and managers would then collect a portion of the ghost employees’ salaries as a kickback. 3

Per Prime Group, Kazakhstan, ‘‘The legal system of Kazakhstan, along with legal system of Italy, France, Germany, and Austria, and other countries, belongs to the Roman-German (continental) legal system as opposed to the Anglo-Saxon legal system (England, the U.S.), where judicial precedents are the main legal sources, Roman-German legal system has a single hierarchically structured system of enacted law sources’’ (see, http://www.prime-group.kz/pdf/2LEGAL_SYSTEM_OF_KAZAKHSTAN.pdf ).

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Employees in warehouses and drilling sites appropriated company materials and supplies for their own profit and that of people close to them. To cover their thefts, they would report higher consumption of materials and supplies in production reports. Supervisors would conspire with other employees in the ‘‘hiding’’ of company assets. Some workers stole equipment from drilling sites and sold it for their own profit. SMG also provided food services to their employees. Cooks and staff involved in cafeteria service would write off food supplies and transfer those supplies directly to a restaurant owned by the Deputy Head of Social Supplies, who was R. Kabaev’s cousin. SMG management and employees employed a great variety of methods to engage in fraud and corruption. Foremen used SMG’s transportation services, equipment, and personnel to provide services to third parties for their own profit rather than the benefit of SMG. Employees would sign maintenance reports for SMG work that was not done, and the cash paid to contractors for incomplete maintenance work at SMG would be split between the contractor and those SMG employees. In another scheme, SMG staff intentionally allowed transportation equipment to deteriorate so that parts could be sold cheaply to transportation contractors. Although there was plenty of corruption in the aforementioned operations, the main cash flows from corruption came from fraudulent operations in SMG’s procurement process. The head of the procurement department, Nik Bervo, was one of R. Kabaev’s closest associates. N. Bervo organized operations and negotiated with the parties involved, thus allowing R. Kabaev to avoid direct involvement. Nonetheless, all significant procurement transactions were controlled personally by SMG President R. Kabaev. The fraudulent procurement process took place in a codified manner. First, the procurement department collected bids from suppliers for desired material or equipment. Second, N. Bervo would negotiate the deal with suppliers. N. Bervo’s intention during price negotiations was not to get the most competitive price, but to determine which suppliers were willing to give a kickback payment. The typical kickback for SMG was 20 percent of the total deal. This was usually split equally between R. Kabaev and N. Bervo. In the contract and other applicable documents, the transaction cost and kickback were aggregated into one price in order to hide the kickback. These documents were signed by President R. Kabaev. Once these suppliers received payment from SMG, they would transfer back the negotiated kickback amount in cash personally to N. Bervo. He would then give R. Kabaev his share. For significant purchases (e.g., drilling bits, spare parts for the rigs, or fuel), N. Bervo would use another scheme. He would find the supplier with the best price and/or the best discounts, but not necessarily the best quality. An associate of either N. Bervo or R. Kabaev would create a company that would sign a contract with SMG to provide that good. The contract would require a pre-payment. The contract price included the price of the supplies from the proposals that N. Bervo obtained from other suppliers, expenses for the newly created company, and an amount for N. Bervo and R. Kabaev. The company supplying SMG would use the funds from the prepayment to obtain supplies, but these goods would be of lower quality since they were the lowest priced. In fact, sometimes the supplies were used and worn out. At other times they were materials stolen from SMG. N. Bervo justified the high costs of materials and supplies by arguing that the company was experiencing shortages of materials needed urgently to continue operations in a timely manner. However, the shortages were based on N. Bervo’s practices of insufficiently reserving supplies, which he justified as a cost-saving measure. To prevent supplies from running out, N. Bervo would make expensive purchases under the pretense that any long production stoppages would result in Journal of Forensic Accounting Research 2017

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losses for SMG. As a result of these procurement practices, SMG suffered high supply costs, inefficiency, and low-quality materials and supplies.

PART ONE REQUIREMENTS 1. Describe, in brief detail, what you consider to be the three most important internal and external fraud risk factors at SMG that occurred prior to the NOS acquisition. Consider and briefly discuss other risk factors that existed as well. 2. Briefly describe Kazakhstan’s culture and history. Discuss how Kazakhstan’s culture contributed to fraudulent activity at SMG. Do you think that SMG management considered their activities to be fraudulent? Criminal? Do you think Kazakh society and the government would have considered these activities to be fraudulent or criminal? 3. Reflecting on the relationship between the old SMG management team and the suppliers, discuss how conflicting interests and pressures led to fraudulent activity. Describe the different types of fraudulent activity that resulted.

PART TWO Anticorruption Measures after the NOS Acquisition N. Bervo’s fraudulent procurement process was well-organized and hidden. Additionally, the President, R. Kabaev, protected N. Bervo. Kazakh corporate culture, and especially the strong power of elites, meant that NOS could suffer major blowback if it chose to dismiss N. Bervo without direct evidence of wrongdoing. This corporate culture is not unique to Kazakhstan; the dominant Russian corporate culture shares many of these norms. In the face of these standards, NOS began to implement new procedures at each step of SMG’s procurement process to avoid corruption, and they focused their efforts on finding information to document N. Bervo’s misconduct. R. Borisov was hired by NOS as Deputy Head of Procurement to serve under N. Bervo and observe his daily activities. R. Borisov also collected data on suppliers and the market. He analyzed the prices of deals made by N. Bervo and compared them to prices in the open market. R. Borisov’s scrutiny created enough incentive for N. Bervo to change suppliers, which led to an increase in the quality of material purchased and a decrease in its prices. At the same time, Y. Schmidt, NOS’s lawyer, collected all active contracts and analyzed SMG’s rights and liabilities with regard to its customers and suppliers. He analyzed potential risks of key SMG assets including land, buildings, and drilling rigs, and he developed measures for asset protection. For example, Schmidt wanted to protect the drilling rigs from being taken over by someone who could win a potential lawsuit. Schmidt worked on improving and implementing internal control procedures. He adapted NOS’s corporate bylaws for procurement procedures and contract work based on Kazakh law and the environment at SMG. The Board of Directors voted to implement these new bylaws, making them mandatory for the company. These new control procedures (see Figure 3) required that deals over $35,000 be subject to Tender Committee approval. This committee consisted of the First VP, the VP of Economics and Finance, the Head of Accountancy, NOS’s lawyer, and the head of the Initiating Department. Contracts over $100,000 were subject to approval by the Board of Directors. Also, all contracts were subject to revision by the Committee before being signed by President R. Kabaev. Y. Schmidt was a Committee member. He used his role on the Committee to screen all company deals, as well as the legal Journal of Forensic Accounting Research 2017

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FIGURE 3 SMG Procurement Processes after NOS Acquisition for Bids over $35,000

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documents of counterparts. Y. Schmidt would examine these documents for legal and corruption risks. The new bylaws made Schmidt responsible for implementation and compliance. He was also responsible for monthly reports to the Deputy Director on LOI for NOS4 and the President of SMG. These reports documented all violations of the new bylaws by SMG’s officials, including those of President R. Kabaev. A. Petrov, the VP of General Affairs, collected and analyzed the information provided by R. Borisov and Y. Schmidt. A. Petrov would then work with regular NOS employees and SMG counterparts to gather data from these insiders about the fraudulent practices within SMG. In addition to this work on documenting corruption, A. Petrov also improved control of production processes. By implementing new reporting forms, he organized proper controls over the use and maintenance of corporation transport and equipment. He hired an independent security agency to secure inventories, warehouses, and other SMG facilities. And along with the VP of Economics and Finance, A. Petrov developed and implemented a new wage system for drilling teams that motivated the teams to work faster and save materials. All of these measures revealed internal corruption mechanisms and structure, aided in removing corrupt executives, and helped to consolidate control of SMG’s finances. Although these measures were successful, the new management still lacked direct evidence of N. Bervo’s involvement in corruption. However, the Deputy Head of Procurement R. Borisov eventually found a supplier willing to confirm that N. Bervo requested illegal kickback payments. On the phone, the supplier confirmed N. Bervo’s request for the kickback payment and provided details of the proposal including amounts and terms. However, the supplier refused to provide any written or give official oral confirmation of this story. This left the management team at an impasse. However, A. Petrov asked a new employee, an IT specialist, to come into the office to transcribe the supplier’s story from dictation. A. Petrov then asked the new employee to write the supplier’s name on the paper and to sign it. Even here we see ethical standards that differ from the ideals advanced in Euro-American practice. If an informant refuses to be named in front of those whom he/she is incriminating, it is unethical to use that informant’s name against his/her will, especially since the informant’s safety may depend on protecting his/her identity. Nonetheless, SMG’s First VP (A. Petrov) and legal counsel (Y. Schmidt) went to the President’s office and placed the incriminating transcript in front of President R. Kabaev. R. Kabaev called N. Bervo into his office and after N. Bervo read and processed the information, N. Bervo quietly wrote his letter of resignation.

TRANSFORMING CORRUPTION The new management succeeded in taking control of SMG’s processes, step by step. However, the unofficial anticorruption team (A. Petrov, R. Borisov, and Y. Schmidt) came to the conclusion that a new corruption system was taking the place of the old one. This new system was strategically designed by the new management, including managers newly hired by NOS for the SMG project. The methods of the system were similar to the old system, but the fraudulent operations were more sophisticated. 4

The Deputy Director on Legal and Organizational Issues for NOS was in charge of corporate development of NOS. He personally controlled the process of establishing a new corporate system in SMG, including anticorruption work, internal control, contractual and corporate legal work, internal organizational issues, and human resources management. He exercised his tasks in SMG though Y. Schmidt and other new SMG employees who reported directly to him. He worked directly with SMG’s Board of Directors and reported to the CEO for NOS.

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The new corruption system was smaller and more organized. V. Semenov (First VP of SMG) and N. Semenov (VP of Economics and Finance) controlled the system, and A. Sernev (Head of the Project from NOS and a member of SMG’s Board of Directors) headed and secured its operations. The system united the people that the Semenovs’ and A. Sernev had brought with them to work at NOS/SMG. However, these managers were careful to employ only corruption methods that were extremely difficult to detect. They were able to formalize their procedures based on N. Semenov’s control over the company’s financial and accounting systems. Due to Kazakhstan’s procedures that place great control in the hands of powerful elites, thus allowing companies to select their auditing company, N. Semenov was able to personally choose SMG’s independent auditor. A. Sernev and the Semenovs’ engineers and supervisors took advantage of the increase in efficiency of the drilling teams by using them to provide services to third parties for their own profit. The majority of corruption profits were laundered by NOS’s $30 million SMG investment program, through shadow companies owned by the Semenovs and A. Sernev.

EPILOGUE At the beginning of 2009, the Semenovs, A. Sernev, and some of their subordinates were fired. Word spread quickly through the drilling industry that companies ought not to hire these former executives. However, no legal action was taken against the Semenovs and A. Sernev, since NOS lacked direct evidence of their fraud. As a result of implementing anticorruption measures in the procurement process, the company saved more than $2,500,000 on key material purchases within the first six months of 2009. Despite the fact that President R. Kabaev was dismissed in Spring 2009, NOS hired him as an honorary consultant without authority. The desire for maintaining an ongoing working relationship on the part of both parties demonstrates the lack of acrimony involved in the case. Although SMG is a particularly extreme example, practices of bribery and fraud are widespread in the Kazakh business community; rather than punishment, maintaining amicable relationships among elites is a Kazakh cultural priority. The NOS Board of Directors appointed one of SMG’s drilling managers who was not involved in A. Sernev and the Semenovs’ frauds to be the new President of SMG. A new Head of Accountancy was also hired at the time. The NOS Board also established a new corporate structure for SMG by abolishing the First VP position and including a lawyer in the SMG staff who reported directly to the President. By the end of 2009, all NOS corporate procedures had been fully adopted within SMG. R. Borisov and Y. Schmidt were transferred to a different NOS company and A. Petrov left SMG in 2010. After a difficult period of recovery, which included only 77,051 drilled meters in 2008, SMG broke its historical record with 227,099 drilled meters in 2010. It became the most profitable company in the NOS group and accounted for 16 percent of the Kazakhstan O&G drilling market. The NOS shareholders that had provided funds for the SMG project began to receive profit payments in accordance with terms of the investment agreements. However, in 2010 the NOS Security Department began to receive reports of corruption-related activities that were being perpetrated by the ‘‘new management.’’ SMG counterparts and employees reported that the practice of shadow companies and kickbacks was back, and that percentages of such payments to the new President are even higher than they were to the old President, R. Kabaev. Drilling and cementing teams received direct orders from the new President to perform works for third parties without any contract, but with direct cash payment to the President. Journal of Forensic Accounting Research 2017

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No one from new SMG management team confirmed these facts; nevertheless, NOS’s Security Department collected a significant amount of evidence that indicated widespread corruption, and presented this evidence to NOS’s CEO. Despite the incriminating data collected, the CEO of NOS did not proceed with any actions against the new CEO of SMG. Again, this lack of concern for high-level corruption points to both Russian and Kazakh norms of protecting elites, and an understanding of a certain level of fraud as being standard practice. The extent of these practices may differ from the U.S. and Western Europe, but analysts ought to seriously consider Western firms’ own practices of protecting their ‘‘elites’’ before dismissing this case as inherently and diametrically juxtaposed to business practices in the U.S. and Western Europe.

PART TWO REQUIREMENTS 1. What were some of the factors that led to the evolution of corporate corruption at SMG? 2. Consider the decisions made by NOS’s management. What else could they have done to improve SMG’s internal control? Is it realistic to expect such actions to be taken given the cultural environment? 3. If SMG were located in the U.S. or other Western countries, do you think it would have been able to execute this same corporate corruption scheme? Why or why not?

REFERENCES Dutta, S. K., D. H. Caplan, and D. J. Marcinko. 2014. Blurred vision, perilous future: Management fraud at Olympus. Issues in Accounting Education 29 (3): 459–480. doi:10.2308/iace-50787 Higgins, H. N. 2012. Learning internal controls from a fraud case at Bank of China. Issues in Accounting Education 27 (4): 1171–1192. doi:10.2308/iace-50177 Holtzblatt, M., and N. Tschakert. 2014. Baker Hughes: Greasing the wheels in Kazakhstan (FCPA violations and implementation of a corporate ethics and anti-corruption compliance program). Journal of Accounting Education 32 (1): 36–60. doi:10.1016/j.jaccedu.2014.01.005 International Monetary Fund (IMF). 2013. IMF Executive Board Concludes 2013 Article IV Consultation with the Republic of Kazakhstan. Press Release No. 13/308, August 14. Available at: https://www.imf.org/en/News/ Articles/2015/09/14/01/49/pr13308 Mellon, M. J., and R. Marley. 2013. Roger’s dilemma: A situational examination of ethical behavior in the presence of internal control deficiencies. Issues in Accounting Education 28 (2): 337–351. doi:10.2308/iace-50365 Reisch, J. T. 1999. Brodnax Minerals Company: A case study on auditors’ responsibilities. Issues in Accounting Education 14 (4): 589–612. doi:10.2308/iace.1999.14.4.589 Stodghill, R. 2006. Oil, cash, and corruption. The New York Times (November 5). Available at: http://www.nytimes. com/2006/11/05/business/yourmoney/05giffen.html

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CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE The primary objective of the case is to engage students in a qualitative analysis designed to detect fraud and corruption activities in an international context. In doing so, students are challenged to consider the impact of culture within an organization and the country/society on corporate corruption. The issues of bribery, corruption, and misappropriation of assets are explored through the case development surrounding the real-world fraud and corruption at South MunaiGas (SMG), one of the oldest Kazakh oil and gas drilling companies in Kazakhstan. Fraud is a serious and growing problem faced by companies internationally. Transparency International’s Corruption Perceptions Index (CPI) suggests the need for action to combat corruption in both the United States and around the world. The 2016 CPI ranks 176 countries based on the perceptions of corruption in the public sector. More than two-thirds of the countries ranked in the Index score below 50 on a scale from 0 (perceived to be highly corrupt) to 100 (perceived to be very clean), which implies that levels of bribery and corruption in the public sector are still perceived to be very high (see Table 1 for Kazakh CPI scores). Similarly, a Global Fraud Survey conducted by EY (2014) noted that more than one in ten executives surveyed reported that their company had experienced a significant fraud event in the past two years. Ten countries recorded a significant increase, including the U.S. (16 percent in 2014, up from 8 percent in 2012), China (8 percent, up from 4 percent), Japan (10 percent, up from 6 percent) and Russia (16 percent, up from 10 percent). By using a foreign company to explore issues, students are challenged to consider the impact of culture on perceptions of corruption and fraud. In addition, students are challenged to consider the adequacy of internal controls in a new, larger, and more complex entity, given the merger of two entities that have different corporate governance structures. Learning Objectives     

Students will gain an appreciation for the impact of culture within an organization and country/society on corporate corruption. Students will identify the internal and external fraud risk factors at SMG that led to development and evolution of corporate corruption in SMG. Students will gain knowledge about fraud types, bribery, and corruption. Students will analyze decisions made by NOS’s management, SMG’s internal control weaknesses. and make suggestions for improving internal controls. Students will recognize corruption methods and tactics.

IMPLEMENTATION GUIDANCE Intended Audience of the Case The case can be effectively used in a graduate or advanced undergraduate level auditing, managerial accounting, corporate governance, forensic accounting, or fraud examination course. This case has been implemented by the authors and instructors at other universities in graduateand undergraduate-level auditing and fraud examination courses. However, given the emphasis on Journal of Forensic Accounting Research 2017

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decision making and critical thinking, the case is appropriate for use in any course listed above, especially with a fraud examination component. Case implementation requires approximately 90 minutes of class time. Introducing the Case The instructor should divide the class into teams and provide students with the case. The preclass preparation requires students to read Part One of the case and prepare written responses to the Part One Requirements questions. In-Class: Part One Discussion Students should come to class with written responses to the Part One Requirements questions, after having read Part One of the case. Teams present and discuss their responses with the class, explaining what methods they used in their case analysis, what risk factors and red flags they discovered, what countermeasures they chose to apply, and what they hope to achieve with each step. During the discussion, the instructor lists key points on the board. In-Class: Part Two Introduction The instructor summarizes class findings made in the previous stages and provides the class with Part Two of the case for in-class reading. The instructor gives the class from 10 to 20 minutes to read Part Two and to think about the Part Two Requirements questions. In-Class: Class Discussion The instructor facilitates a discussion by using the Part Two Requirements questions and encouraging students to compare each team’s responses for the Part One Requirements questions with the decisions made by NOS and SMG management, as described in Part Two of the case. Students should evaluate the efficiency and effects of ideas and anticorruption methods they proposed and methods that were used by an actual management team. This allows students to apply professional knowledge and critical-thinking skills, and to guide one another through the reasoning process as to why particular methods are, or are not, efficient in this case. After identifying the most suitable anticorruption methods, the instructor guides a class discussion of the appropriate alternative plan of action. As students provide an action plan, the instructor writes each step on the board, thus providing a basis for a cumulative class action plan. In-Class: Case Outputs In the final stage of Part Two, the instructor summarizes findings of the case and facilitates a brainstorming discussion that encourages students to think about corruption as a constantly developing phenomenon and whether it is possible to eliminate corruption completely. Implementation Timeline Based on two implementations of the case, the authors estimate the following timeline: Journal of Forensic Accounting Research 2017

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Case Activity Pre-class: Preparation In-class: Part One Discussion In-class: Part Two Introduction In-class: Class Discussion In-class: Case Outputs Total in-class time Total case time

Estimated Time 45 minutes 30 minutes 25 minutes 25 minutes 10 minutes 90 minutes 135 minutes

Evidence of Classroom Validation The case was administered to undergraduate and graduate students in both internal auditing and external auditing classes at three universities. A total of 81 students completed the case. These courses and the students’ educational backgrounds gave them a firm working knowledge of bribery and corruption, and the case further expanded their ability to apply this knowledge. The case requirements were constructed to help guide the class toward achieving the learning objectives; these requirements also provide direction for class discussion. Students were asked to provide feedback after completing the case; the results of this survey are included in Table 2. The students were asked to respond to specific case objectives and to the case as a whole using a seven-point scale (1 ¼ strongly agree, 7 ¼ strongly disagree). The student responses indicate that they feel the case meets the objectives and is a good learning experience. Both graduate and undergraduate students expressed positive and constructive views about the learning opportunities and realism presented by the case. For example, one student commented, ‘‘Really enjoyed reading the case, helped me understand the importance of internal controls. Also painted a good picture of why separation of duties is important. Also the impact of cultural norms and environment.’’ Another student said, ‘‘This case was very interesting. I thought it was good to learn how different countries will have different risks of fraud based on their culture. I welcome more cases in other countries.’’ Additionally, another student noted, ‘‘Details of the case are very complete, help to understand the actual situation of the whole case.’’ One student commented, ‘‘It’s a little too long, can make you procrastinate on doing it. After reading, it was good to learn about culture effects on business.’’ The feedback from faculty who implemented the case was positive as well. For example, one faculty member commented, ‘‘I really liked the case and the students were engaged in the discussion of the issues. They verbally expressed shock and surprise from the case facts and were immediately able to rule out many of the corruption tactics in reference to U.S. laws and business practices.’’ Survey responses indicate that undergraduate students spent an average of 72.32 minutes to complete the case, and graduate students on average completed the case in 263.94 minutes (untabulated).5 This time difference reflects varying commitments and time demands of undergraduate and graduate students, as well as the level of analysis offered by the two groups.

TEACHING NOTES AND STUDENT VERSION OF THE CASE Teaching Notes and the Student Version of the Case are available only to non-studentmember subscribers to Journal of Forensic Accounting Research through the American 5

The graduate students who participated in the case activities did not receive any formal instructions from their instructor.

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TABLE 2 Student Evaluation of the Learning Objectivea

Survey Item I learned additional knowledge about the impact of culture within the organization and country/society on corporate corruption. I learned additional knowledge about identifying internal and external fraud risk factors. I learned additional knowledge about fraud types, bribery, and corruption. I learned additional knowledge about identifying factors that can lead to corporate corruption. The case provided a good opportunity to identify internal control weaknesses, including management override, and suggestions for improving internal controls. The case provided a good opportunity to recognize corruption methods and tactics. It was a valuable educational experience to complete a case that is based on detecting fraud and corruption in a different cultural environment. I would benefit from having more cases like this one where I can apply knowledge that I have learned. a

Mean Response Grad Course

Mean Response Undergrad Course

Mean Response Grad and Undergrad

1.50

1.73

1.61

1.67

2.01

1.84

1.81

2.07

1.94

1.67

1.96

1.81

1.69

1.57

1.63

1.78

1.77

1.77

1.58

1.73

1.66

1.75

1.73

1.74

1 ¼ Strongly Agree; 2 ¼ Agree; 3 ¼ Somewhat Agree; 4 ¼ Neither; 5 ¼ Somewhat Disagree; 6 ¼ Disagree; 7 ¼ Strongly Disagree.

Accounting Association’s electronic publications system at http://aaapubs.org/. Non-studentmember subscribers should use their usernames and passwords for entry into the system where the Teaching Notes can be reviewed and printed. The ‘‘Student Version of the Case’’ is available as a supplemental file that is posted with the Teaching Notes. Please do not make the Teaching Notes available to students or post them on websites. If you are a non-student-member of AAA with a subscription to Journal of Forensic Accounting Research and have any trouble accessing this material, please contact the AAA headquarters office at [email protected] or (941) 921-7747.

REFERENCES Ernst & Young (EY). 2014. Global Fraud Survey. Available at: http://www.ey.com/Publication/vwLUAssets/EY-13thGlobal-Fraud-Survey/%24FILE/EY-13th-Global-Fraud-Survey.pdf

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