13 Sep 2018

Clayton Utz Fundamentals of Financial Crime 04 Financial statement manipulation

In our fourth Fundamentals of Financial Crime, we'll look at some common themes in financial statement manipulation – what drives it, and how to spot it and reduce the risk.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.

TRANSCRIPT

Meg McKechnie: So often financial crime is seen as a victimless crime. It's not.  So many people are impacted by what is recorded in the financial statements of an organisation: for example shareholders or suppliers or potential acquirers of a company may be influenced by the contents of your financial statements.

Daniel Heywood: There's one method that can be deployed by financial statement writers and that is to use improper revenue recognition policies; they're bringing forward revenue into a period where they're actually pushing out their earnings, or might actually create fake sales and fake invoices to bump up their earnings as well.

Meg McKechnie: And that probably leads to the expense side which is another way that you can manipulate financial statements. For example, you might be understating your depreciation or amortisation write-offs each year, or you might be improperly extending the life of an asset that should actually be written off.  Another method on the expense side is that you may be deferring expenses to a later period to improve the results in the current period

Daniel Heywood: That's right, I've actually seen that in a recent example. We were engaged by a purchaser of a company. The purchase price was based on earnings times a multiplier. Now, that earnings number was actually manipulated by the management that was in the company at the time. What they had done was they had pushed up revenue numbers through channel stuffing and also recognising revenue early on consignment stock when it's delivered, not when it's actually sold.  They actually went through and did it on the expense side as well – so, bumping up earnings by pushing down expenses, and they didn't write off stock that was obsolete.

Meg McKechnie: It probably leads to how do we find this when we're conducting reviews of financial statements.  Analytical tests are key to this.  One of the key ones is on the revenue side. You referred to an overstatement of revenue – well, why don't you test your revenue against cash movements and see if there's any disconnect there? If you know there's a huge amount of revenue, but the cash receipts don't seem to correlate, then there may be a problem in there. 

Another thing on the expense side is look at the payment terms with customers and see where there's been a change to terms or where you know customer purchases have been blown out.

Daniel Heywood: I think you should look at the strength of management and its integrity and the integrity of the board.  Make sure there's proper segregation of duties in there, and internal audit committees that are well rehearsed in looking at financial statements.

Meg McKechnie: And the other thing you might want to look at is any changes to accounting policy or procedure. Test where that has occurred and see whether it's a legitimate change or if it may have been used to improve the financial position of the organisation.