Cooking the Books

In this episode, we look at how some companies "cook the books", why the pressure to meet expectations can lead to creative reporting, and the signals that something in the accounts isn't quite right. Not every fraud involves fake invoices or stolen cash. Sometimes it's just accounting!

Transcript

Simon (2) 0:05

Welcome back to Fraud Files. My name is Simon, and I'm the interviewer on this podcast, which brings you real life case files and forensic insights into a number of white collar frauds, financial crimes and misdemeanours that your host Edward has personally encountered, and in some cases brought to light, during his financial, corporate and business career. He shines the spotlight on both the frauds and the perpetrators. In this episode, we're raising the lid on what's referred to as: Cooking the Books. It's not about culinary skills I'm afraid, but about the deceptive practices that the senior managment in companies can use to manipilate the financial numbers. Over to you Edward.

0:47

Hi. Well, as an auditor, um, I've seen it all firsthand and, uh, the potential for fraud is, uh, truly staggering. In this episode, we'll explore how creative financial. Techniques can be used to paint a distorted picture. And, uh, and I'm going to share some specific examples to illustrate, uh, the real world impact of what can be done.

Simon (2) 1:20

So we're talking about deliberate financial statement misstatement, primarily by the directors or senior management of a company.

1:27

Yes, the playbook is quite cunning. We're talking about things like manipulating the accounts through revenue recognition where companies might. Prematurely record sales in order to boost profits. Uh, then there's inventory manipulation. So that's, you know, inflating say the, uh, closing stock to artificially increase gross profits for the period. And, uh, let's not forget the creative side of depreciation and amortization. Uh, where that can have a marked impact on the bottom line. And also, uh, this tinkering with, uh, provisions in order to, uh, mask potential losses. So these are all examples of deliberate attempts to mislead, hoping that the. Financial statements, misstatements, if you like, will fly under the radar of the auditors. And often it's a constant battle between management and the auditors. And of course, the auditor's duty is the truth and transparency

Simon (2) 2:36

And what are the main reasons why a company would want to cook the books?

2:39

Well, often it boils down to pressure to meet market expectations. Uh, particularly in the case of, uh, publicly traded companies boosting stock prices to attract, uh, investors or to secure better financing. Uh, sometimes it's about maximizing bonuses for executives or even just trying to hide poor performance. The motives can be diverse, but the end goal is often the same, creating a false narrative that deceives shareholders

Simon (2) 3:12

Is it always about trying to increase reported profits?

3:15

No. In owner managed companies, the motivation can definitely shift towards minimizing profits often for tax purposes, this might involve aggressive expense recognition or deferring revenue or, or even creating questionable provisions to reduce taxable income. So it's another form of manipulation just driven by different objectives.

Simon (2) 3:41

What sort of creative accounting did you come across during your time as an auditor?

3:46

Well, creative accounting, or let's call it window dressing of the accounts and profitability of the company, or even its balance sheet. It's, often quite, easy to do given that the, uh. Financial statements, uh, rely on quite a bit of judgment and subjectivity and estimates, uh, believe it or not, but it's not a precise science and management does have to, make assumptions about various, uh, aspects of the, uh, the business and the, uh, transaction cycles. And, um, and, and this affords them some leeway to, uh, to dictate what the bottom line is going to look like.

Simon (2) 4:29

So external audits are important in detecting if the accounts have been artificially manipulated?

4:35

It's the auditors who really are the, uh, the first line of defense, if you like. Against, manipulation of the profitability of the company and, and window dressing. And often it's sort of cat and mouse between the auditors and management. I mean, ultimately, you know, the revenue t

Simon (2) 4:52

the tax man

4:54

would be concerned about, the profits not being true and accurate, particularly if that was leading to an understatement of profits and reduced tax payable, or, deductibles being put through tax computations, which ought to have been disallowed. So often it's the auditors, you know, say a first, first there, and, um. You know, management often will try and, you know, prey on the auditors. So, uh, the management are, approving the audit fees that the company gets charged by the auditors and then is paying for. So in a sense, you could argue that, uh. Management has a certain amount of leverage over auditors, particularly in cases where those audit fees are substantial. And, you know, we've seen this time and time again where the auditor's, position has been compromised, because of fees, for example. And, so the, management will often, try to assess. How robust the auditors are. Um, I've been in a situation where we believed that the audit room in which the audit team was working, uh, was actually being bugged by, management, and we came across some, uh. Some very unusual looking devices in the room. Um, uh, needless to say, once our suspicions were raised, um, those devices didn't seem to be there the next day, uh, so, um, you know, yes, skullduggery does happen in the corporate world. It's sort of quite a harsh world out there. And, uh, a determined management team that wants to produce a certain set of results, um, will do its damnedest to achieve that, uh, by any means.

Simon (2) 6:32

Bugging devices. wow. Okay, so can you give us some specific examples of the financial statement deceptions you came across as an auditor?

6:42

Well, the, the principle areas that I came across, when I was an auditor. Where the, financial statements, were, being, uh, tinkered with if you like, you know, one of those areas was in the area of, revenue recognition. So, management were manipulating the revenues that were being recorded in a particular accounting period. Another area was in the area of reserves and provision accounting. So, where the management were manipulating the provisions to either increase or decrease profits depending on what their aims were. Depreciation and amortization was another area, so having a particular policy on the manner in which capitalized costs and assets were being depreciated. Or capitalized costs were being amortized under the matching principle. And this is an area where there is a, good deal of, subjectivity, uh, permitted. But again, management will often take advantage of that. Another area was in the, inventory, and stock. Valuations at year end. Uh, at the end of the year, an assessment is made, to quantify and, and to price out the, stock value at the end of the year in a company, particularly in the case of a manufacturing company or, let's say a trading company, or where there's goods involved. That stock number, you know, has a direct impact on the number that's, derived for the cost of goods that are sold, and therefore that has a direct impact on the amount of profits for the year. So I myself, uh, specifically and personally. Uh, as part of the audit team on, uh, on the audit of, uh, one particular client, uh, I uncovered, uh, where the client had, manipulated their closing stock, by altering the data relating to the physical year end stock count. And again, say in that case the cost of sales and therefore the profits were. Affected. So I also came across, uh, and personally uncovered. Uh, on an audit, a situation where in the company the accounting department was processing journals to the general ledger at year end, in terms of the stock pricing and the stock valuations and the, um. The program to actually, uh, record the stock values, uh, already had those same adjustments built in. So effectively you had a double counting, in the accounting department and the programming of the IT department. Uh, so on a line by line basis, there was this, double counting situation. Um, now in, in those sort of situations, um, uh, materiality has to come into account. As well from the auditor's perspective. So they're not going to, be worried about amounts that are less than a, than a certain material factor in terms of the, the truth and fairness of the accounts. And typically, these issues are brought to the attention of management of, as part of the audit process. Adjustments are then made to the accounts, uh, as audit adjustments so that the accounts when they go out are. Or have, been corrected. And, that management may or may not take action towards the culpable parties or individuals, as they see fit.

Simon (2) 9:53

It sounds like there are a lot of cooks in the kitchen, too many, spoiling the broth!

9:57

I suppose to summarize, uh, you know, what we're talking about really in this case of cooking the books, often it's, it's manipulation of the financial statements. For whatever reason. Um, and, uh, we're not normally talking about in this instance, uh, outright fraud because, uh, outright fraud is going a lot further than cooking the books. Outright fraud is where somebody is, uh, benefiting, uh, you know, personally or somebody or a group of individuals are benefiting, uh, from deception. Having said that, even though it may not be outright fraud, financial statement, misstatement is still, in many cases, going to be an illegal act. And the consequences, can be criminal in nature. And people have found themselves in jail for, um, for manipulating the financial statements. A good auditor is going to do his utmost to try and uncover attempts at, uh, at the manipulation of financial statements. Uh, a good auditor is going to substantiate, is going to verify, is going to reconcile, is going to challenge, is going to investigate, and, uh. This is what, will bring the, actions of a, management team that's, cooking the books, it's going to lift the lid on that. Good auditors will do that. Uh, that's what audit tests are designed to do.

Simon (2) 11:30

So that's this week's episode. If you'd like to hear more episodes of fraud files Follow the podcast on your usual platform or on the Fraud Files website. Thanks for listening.