Revenue Recognition Fraud: Methods and Reason

In today’s corporate arena, fraud has taken its seat among the top priorities of those who make policies and set standards. The majority of large-scale fraud is perpetrated by the improper recognition of company revenues and is, in practice, generally simple. Revenue recognition fraud can be carried out by keeping the books open past the end of the accounting period, recording consignment goods as sales, improper bill-and-hold transactions, failure to record offsetting accruals, and many other methods that boost earnings.

Internal auditors need to understand the types of revenue recognition fraud and the internal controls that prevent the use of improper techniques. This knowledge will allow them to help management and the board of directors in protecting the reliability of financial reporting. Techniques for Revenue Recognition Fraud Revenue recognition fraud is not always difficult to understand. In many cases it’s rather easy to see once someone points it out. In his article “Timing is of the Essence,” Joseph T.

Wells explains that the most common method of revenue recognition fraud is holding the books open past the end of the accounting period. He states, “proper accounting cut-off tests prevent most of these problems, but not all,” [Wells 2001].

He goes on to explain that companies can stop time clocks and continue shipping goods until sales targets are met, but competent auditors should notice that something obvious or at least suspicious is happening. Playing with time is not the only way to improperly recognize revenue. Another way to commit revenue recognition fraud is by recording goods on consignment as sales.

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Fraud In Revenue Recognition

Consignment goods are those that a party ships to a selling agent. The shipment of these goods to the selling agent should never be recorded as a sale because they are still inventory of the consigning company. This method of revenue recognition fraud is detected by the reversal of sales that must take place in order to correctly record the revenue. Again, auditors should be able to identify these situations and take necessary actions [Wells 2001]. Along with these two methods, bill-and-hold transactions can be used to prematurely recognize revenue.

Douglas R. Carmichael, in his article “Hocus-Pocus Accounting,” says that bill-and-hold scams are “difficult to audit and have long been associated with incidents of financial fraud,” [Carmichael 1999]. In a bill-and-hold transaction, after the customer says they will purchase goods, the seller bills the customer and holds the goods until the customer requests delivery. Even though this is not a GAAP violation, the SEC does have a checklist stating requirements that a transaction must fulfill in order to recognize the revenue.

A method of premature revenue recognition that is a violation of GAAP is the failure to record offsetting accruals. This is a GAAP violation because unless you have completed your services you cannot record the entire amount of revenue [Wells 2001]. There are many organizations that receive payment in advance for services that they have yet to complete. Apartment complexes, magazine companies, and others would benefit in the short run by eliminating the liability and increasing the revenues. The deterrent to this fraud technique therefore is the GAAP rule.

These methods of improperly recognizing revenue are illegal, prevented by GAAP, or detectible by auditors. Yet this type of fraud today seems to be more widespread and newsworthy. Why are so many companies failing to meet the standard of business ethics that we are taught in school? Pressure. “Public companies feel pressure to report quarterly earnings that meet or exceed analysts’ expectations – after all, failure to meet those expectations can hurt companies’ stock prices,” says Carmichael [Carmichael 1999]. Companies determine their success to a great extent by their stock prices, and rightly so.

Corporations and industries can rise and fall from the interest or trust of the investing public. This pressure from the public can create potential problems within organizations. The Control Environment’s Effect on Fraudulent Revenue Recognition The Committee of Sponsoring Organizations, COSO, has established the widely accepted definition of internal control. This definition includes an area of internal control labeled the control or internal environment, which has seven components. Each of these components has an effect on every business that is in existence.

There are two, however, that, if not taken into consideration, can lead to unethical decisions such as revenue recognition fraud. The first control environment component is commitment to integrity and ethical values, which means that management should strive for a culture that stresses integrity. Also, “top management should make it clear that honest reports are more important than favorable ones,” [Romney and Steinbart 2003]. If this were truly stressed in organizations, improperly recognizing revenue in order to boost profits would be a problem rarely found.

The second and possibly more important component of the control environment is management philosophy and operating style. In an ideal organization this would be the channel through which commitment to integrity would flow. In this component it is stated that “the more responsible that management’s philosophy and operating style are, the more likely it is that employees will behave responsibly in working to achieve the organization’s objectives,” [Romney and Steinbart 2003]. However, in many instances this is not the case.

Pressure from many directions causes a shift or change in management philosophy, and as the weakness in these two areas grows, the potential for revenue recognition fraud increases. Kyle Anne Midkiff gives an example in “Finding Fraud: Know the Warning Signs and Avoid the Problem,” where “in a division of a publicly traded company, management created an environment, in which achieving budgeted earnings was of paramount importance and needed to be accomplished at any cost,” [Midkiff 2003].

This philosophy is in striking contradiction to that desired by COSO, and therefore lacking a good control environment. This overwhelming stress on meeting budgeted goals and analyst’s expectations drives managers away from integrity and towards a success only mindset, which can lead to implementing one of the various methods of revenue recognition fraud. Conclusion Since the board of directors depends upon the internal auditors assessments of risks and controls, the internal auditors are crucial to maintaining a reliable financial reporting environment.

The forms of revenue recognition fraud are many. Playing with time, recording consignment goods as sales, improper bill-and-hold transactions, and failure to record offsetting accruals are some of the many methods to improperly recognize revenue. These methods in practice are not terribly difficult to understand, and in many cases are limited by statue, policy, or audits. However, as Joseph T. Wells stated, “even adequate internal controls can be overridden by management,” [Wells 2001].

Therefore, the only way to eliminate revenue recognition fraud, in my opinion, is to change management philosophy to mirror that of COSO’s definition. For this to happen, pressure to meet expectations must not sit atop the pyramid, but instead be replaced by an unrelenting drive to secure the company’s integrity for its employees, shareholders, and customers.

Works Cited

1. Carmichael, Douglas R. “Hocus-Pocus Accounting. ” Journal of Accountancy 188. (1999): 59-63.