Fraud in the Mining Industry

Judy, a CFE, was an internal auditor for QRW Mining Company, which had copper, iron and nickel mines around the world. She had her eyes on a mine that QRW had closed two years earlier. The company had told the federal government that it had reserved a large amount to cover reclamation and revegetation costs. However, she compared the actual amount against the company’s promise, and the numbers did not match. And when she visited the site, she discovered that QRW had not filled in the strip-mine site, which had become an overflowing pond.

Though this case is fictitious, it is indicative of mining frauds worldwide. The economics of the global mining industry can be unpredictable. Mining prices often are not stable, and the global economic crisis has affected the industry adversely: the demand of mining products is dependent on customers’ buying power and consumption. Some mining companies and their employees can be driven to fraud. However, auditors and fraud examiners working for mining companies can deter fraud through savvy preparation and detailed organization.

Fraud in the mining industry can be divided into four types: environmental, forestry, occupational and reserves or resources reporting. (Mining-safety fraud, a possible contributing factor to many recent mining disasters, is an important, but separate category, that probably requires a column of its own.)

ENVIRONMENTAL FRAUD

Governments worldwide try to heavily regulate the mining industry’s disposal of hazardous material and waste to help prevent water and air pollution. A mining company is obliged to maintain an ecosystem’s sustainability by minimizing environmental impacts. After a mining company digs the land and extracts minerals, it should, of course, fill the hole and replant vegetation. If a company intentionally breaks contamination laws, it can be accused of environmental crimes and brought to court.

A mining company should create a corporate fund with an estimated amount for mine closure, reclamation and rehabilitation costs as a guarantee to the government that it will fulfill its obligations.

Non-governmental organizations and those who live near mining sites often report mining companies are not living up to their environmental responsibilities. They tend to spend as little as possible on necessary facilities to protect the environment, often do not reserve sufficient money for cleanup and are not willing to backfill and replant vegetation.

If you are in this field, you should ensure that your companies and clients comply with internal and external regulations and focus on detecting fraud risks in environmental management. (And many of these principles are applicable to other industries.) For example:

• Compare the reclamation and mine closure plan with plans for previous years. The main principles behind reclamation are that a mining company is prohibited from allowing former mining pits to become ponds, and they should have sufficient funds to rehabilitate and recover the environment after the pits are closed. Visit mining sites to check the company’s veracity.
• Be suspicious if the actual amount for reclamation and mine closure that the company laid aside is lower than the original estimation. 
• Completely review the reclamation and mine closure plan, conduct reasonability tests and recalculate all the elements.
• During an on-site visit of a former mine, discover if the company has provided facilities and infrastructure to contain pollutants and hazardous materials, has managed the treatment of acid water flow from the mining pit and has not severely contaminated the environment.
• Review the company’s environment department reports or those from any parties that report to management on environment contamination or noncompliance. 
• Be suspicious if you find payments to a government official that do not indicate clear and legal purposes; they could signify bribery or at least illegal gratuities. 

FORESTRY FRAUD

Mining companies, which often excavate in jungles or heavily forested areas, often have to apply for expensive licenses or permits before they cut down trees. However, many companies will clear forests and then apply for governmental permission or will not apply for it at all. Moreover, before a mining company chops down one tree, the government often requires indemnification or compensation to the government for estimated removal. Internal auditors and fraud examiners should work to minimize forestry fraud. For example:

• Review licenses and permits to determine if the company has obeyed all stipulations and paid all fees, and then inspect the mining site to make sure the deforestation matches the intended actions described on the governmental forms. You can use a global positioning device to see if the area compares with the dimensions the company provided on the licenses and permits and to ensure that the company stayed within the intended boundaries. Many auditors and fraud examiners might not use this technical approach because they think it is the responsibility of government inspectors.
• Again, check those payments to government officials that don’t appear to have clear and legal purposes because they might be bribes or illegal gratuities.

OCCUPATIONAL FRAUD

The ACFE, in its 2010 “Report to the Nations,” defines occupational fraud as: The use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.

This broad definition encompasses a wide range of misconduct by employees, managers and executives. Occupational fraud schemes can be as simple as pilferage of company supplies or as complex as sophisticated financial statement frauds. Occupational fraud and abuse is a significant problem faced by organizations of all types, sizes, locations and industries.

Many auditors hold the classic misperception that risks are only related to accounting errors and faulty operations. Enterprise Risk Management, plus Governance, Risk Management and Compliance might be popular methods, but they do not include sufficient anti-fraud shields. You should always “think like a thief” when you’re examining written policies and procedures and when you are interviewing subjects to identify weaknesses or inadequate internal controls.

Mining companies, like many organizations, find it difficult to maintain effective internal controls and oversight of remote locations. You should know the anti-fraud controls, supervisory monitoring systems and working climates at specific mines and not just at corporate headquarters. Of course, poor monitoring systems can allow mining subordinates to neglect prudent and professional work and established procedures and, at worst, commit fraud.

The ongoing global economic downturn is contributing to fraud. The ACFE, in its recent “Occupational Fraud: a Study of the Impact of an Economic Recession,” contends that the presence of the three sides of the fraud triangle — pressure, opportunity and the ability to rationalize illegal behavior — might rise in periods of economic hardship.

According to the report, organizations and individuals can experience the pressure of increased financial strain. Opportunities for fraud can proliferate as many companies lay off their employees and reduce expenditures, which perhaps might lead to reduction of internal controls and fewer proactive fraud prevention measures. Moreover, bombardments of bad financial news, according to the report, can cause mounting feelings of helplessness, pessimism and isolation, which might, in turn, allow individuals to rationalize previously unthinkable acts.

Nearly half of the survey’s respondents said that increased financial pressure has been the largest contributing factor to the observed increase in fraud. Though the economic downturn might not have affected the mining industry as much as other sectors, this is still valuable information; if you know in these uncertain economic times that fraud risks and frequency will increase, you can construct tailored, proactive programs to prevent and deter crimes. For example, you can identify fraud risk in expenses; purchasing; contractors’ reimbursements; and in liquid, precious and movable assets such as fuel, spare parts, etc. On the revenue side, you should assure that sales teams have set the selling (contract) prices fairly.

Also, internal auditors can use the American Institute of CPAs’ Statement of Auditing Standard (SAS) No. 316, which gives general guidelines for assessing fraud risk (i.e., asset misappropriation) and how to identify risk factors.

Financial Reporting Fraud

The global economic downturn as a risk factor can pressure company executives to file misleading financial reports.

SAS No. 316 cites industry and economic conditions as risk factors in evaluating fraudulent financial reporting. Unstable selling prices of product and purchasing prices of input, low confidence in receivable collections and decreases in buying power become potential pressures for company executives who have to achieve financial targets.

When you are detecting for fraudulent financial reporting, you should search for the use of such techniques as illegal earnings management, “window dressing” and financial numbers games. You can apply audit objectives like existence and occurrence, completeness, valuation and allocation (including cut-off tests, accuracy, etc.) especially when you are testing internal controls and transactions.

Run the classic tests to detect fictitious transactions, mark-up reporting and incorrect applications of accounting standards. Be sure to use the principle of “substance over form” when analyzing complex transactions because fraudsters can wrap fraudulent transactions with window dressing to deceive external parties. (To learn more about these concepts, see the “Financial Transactions & Fraud Schemes” section of the ACFE’s Fraud Examiners Manual and many books on auditing, forensic accounting and fraud examination in the ACFE Bookstore.)

RESERVES OR RESOURCES REPORTING FRAUD

Mining scams are “as old as the hills.” These frauds, which part investors from their money, are based on the eternal desire to get rich quick. In mining, like most things, if it sounds too good to be true, it usually is. Some of the frauds are sophisticated and fool even knowledgeable investors.

Witness the infamous Calgary-based Bre-X Gold Minerals Ltd. debacle of the late 1990s, in which a much-touted gold resource of supposedly more than 70 million ounces in Indonesia turned out to be worthless. Samples of drill cores had been “salted” with gold. Assays correctly reported the gold which, unfortunately, had been introduced into the samples in a sophisticated scheme to dupe investors. Stockholders saw share prices fall from more than C$200 to 6 cents before the stock was pulled from trading on the Toronto Stock Exchange in 1997.

Crooked mining companies falsely increase the amount of resources and reserves to attract investors to sink their money into projects. Following are some common warning signs of mining fraud:

• The company has a secret or proprietary process to extract from rock gold, silver or platinum that conventional tests cannot detect. 
• Instead of selling shares of stock, the company is offering to sell the ore itself and extract the metal from the ore for a fee. This is known as a dirt-pile scam. The promoters, by not selling shares, are avoiding regulatory oversight, which smooths the way to take investors’ money.
• Mining companies describe their resources as “measured,” “indicated” or “inferred,” depending on how much they can guarantee using established sampling and testing methods. Then the companies’ reserves — the economically mineable parts of measured mineral resources — can be listed as “proved” or “probable.” As an auditor or fraud examiner, you can use these mining companies’ evaluations as beginning points for discerning the validity of resources and reserves, plus investors’ risks.
• New, unknowledgeable investors should employ geological or mining services. They should call government mining regulators, state geological departments and securities regulators to find out if they have heard of the companies and their projects. They should also ask companies’ representatives if: 1) the companies have ever produced the commodities they purport to offer, 2) where the commodities were produced and 3) how much was produced. Then they should check out this information with local officials. 
• If a proposed investment is significant, independent consultants — paid by the investor — should visit the site, talk to company representatives, take samples and perform an evaluation of the project. Spending a little money on a consultant in the beginning might save a lot of money in the long run. If the company objects, this might be another red flag.  

ROLES OF AUDITORS AND FRAUD EXAMINERS

Of course, most auditors and fraud examiners do not have sufficient knowledge and experience in geology or mining, but auditing standards allow for a third-party expert opinion to verify, for example, mineral resources and reserves.

The discovery of the Bre-X scandal in early 1997 was the trigger for the formation of the Mining Standards Task Force (MSTF) by the Toronto Stock Exchange/Ontario Securities Commission July 28, 1997. The MSTF report (TSE/OSC Mining Standards Task Force, 1998) recommended that each mining company create a “qualified person” (third-party expert) program and codes for estimating, classifying and reporting resources and reserves.

The Canadian Institute of Mining, Metallurgy, and Petroleum is developing a mining valuation code. It will incorporate the MSTF model and will be based on the VALMIN Code (code for the Technical Assessment and Valuation of Mineral and Petroleum Assets and Securities for Independent Expert Reports), originally developed by various Australian professional mining, scientific and financial associations.

Therefore, if you are working as an auditor or fraud examiner for a mining company you would do well to hire a third-person expert who qualifies under “qualified person” best practices and the VALMIN Code because, ultimately, you will have to vouch for that expert’s findings presented in financial statements or an annual report.

According to mineral valuations expert Trevor R. Ellis, the valuation of mineral properties in the U.S. is regulated by the Uniform Standards of Professional Appraisal Practice and the U.S. Securities and Exchange Commission. (For more information, see Ellis’ 2000 paper, “The U.S. Mineral Property Valuation Patchwork of Regulations and Standards.”)

FOUNDATION FOR PREEMPTIVE PREPARATION

Deterring and detecting fraud at a mining company can be a complicated process. Far-flung operations, decentralized management, complex environmental regulations and economic pressures can make the work of auditors and fraud examiners difficult. However, the basics in this column can become a foundation for preemptive preparation that could save millions in losses because of fraud.

Diaz Priantara, CFE, CPA, was an internal auditor with a mining and energy company. He is now an internal auditor with PT Bank Mandiri Tbk in Jakarta, Indonesia.

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