Many studies conducted over the years have found that the most common vehicle for financial reporting fraud has been improper revenue recognition – although in a minority of periods this has been exceeded by manipulation of so-called “cookie jar” reserves, which are bogus estimated obligations that can be opportunistically reversed to compensate for earnings shortfalls.  Revenue recognition abuses include both the deliberate mis-timing of recognition of otherwise-valid revenue, and the outright fabrication of revenue that does not deserve recognition at all.  There are several reasons why improper revenue recognition has proven to be the easiest route to perpetration of financial reporting fraud.

Article Highlights

  • Manipulation of reported revenue may be the most efficient single instrument in the would-be fraudster’s toolkit.
  • The likelihood of any small set of revenue transactions being subjected to scrutiny, absent any “red flags” suggesting their nature as outliers, is generally very small.
  • Fraudulently reported revenue, having no associated costs that need recognition, will have an out-sized effect on reported earnings.
  • Because the proper accounting for purchase discounts is presumed to be universally understood, as well as seemingly immaterial, it escapes the attention it deserves.

First, not only is revenue the largest category affecting the typical entity’s financial position and results of operations, it is, itself, often the single most important indicium impacting the reporting entity’s share price, and thus, inter alia, the company’s ability to make business acquisitions using its stock as currency, and on the value of stock options and other incentive compensation instruments granted to its executives.  In other words, manipulation of reported revenue may be the most efficient single instrument in the would-be fraudster’s toolkit.

Second, because the total volume of revenue transactions is typically quite large, the incorporation of a small fraction of bogus items may be expected to escape close examination by outside auditors.  Indeed, audits must and do rely on examination of small samples of transactions and balances, and traditionally more attention is directed at balance sheet accounts than at items reported in the income statement.  (Of course, bogus revenue will give rise to fictitious receivables – subject to heavy balance sheet testing – and those must somehow be “collected” via other false entries; this will be addressed in a separate article.)  The likelihood of any small set of revenue transactions being subjected to scrutiny, absent any “red flags” suggesting their nature as outliers, is generally very small.

Fraudulently reported (not merely improperly timed) revenue, having no associated costs that need recognition, will have an out-sized effect on reported earnings, which is yet a third reason why bogus revenue is an appealing tool for effecting financial reporting fraud.  Applying purely quantitative materiality guidelines, what might have been a minor overstatement of revenue – and thus not chosen for examination – could quite possibly have a major effect on reported earnings or on other key performance indicia, such as gross margin.  Although auditors are expected to give careful consideration to a range of factors, including qualitative ones, in making the materiality judgments that drive audit scope decisions, eschewing simplistic gauges such as a fixed percentage of revenue, the fact that material revenue recognition frauds are so common confirms that many of these do still escape detection during otherwise well executed annual examinations.

Fourth, there exist a wide range of techniques by which revenues can be either accelerated or wholly fabricated, and these are fairly well understood and available for utilization by those who may be inclined to commit financial reporting fraud.  Of course the SEC and other law enforcement agencies, as well as attorneys advocating for investors and others victimized by fraudulent management practices, are equally aware of these devices, but, as is often the case, perpetrators are constantly formulating new variations on common themes, and thus may maintain a real, if temporary, advantage over even the most committed auditors and enforcement authorities.

For example, although the more mundane forms of channel stuffing (i.e., encouraging intermediate or final customers to accept early excess shipments of goods that do not actually qualify as revenue producing transaction because of, e.g., unusually generous return privileges) are well understood, more subtle variations such as granting (and accurately reporting) unusual discount terms to encourage customers to accept excessive shipments may be less apparent.  Indeed, the latter is a form of “real window dressing” – as distinguished from the fraudulent version – that probably cannot be barred by accounting rules, although strict requirements for informative disclosures, including in both the SEC-mandated management discussion and analysis [“MD&A”] and in the financial statement footnotes, can reduce the likelihood of engaging in such tactics.

A final reason for the popularity of revenue recognition as an avenue by which to commit financial reporting fraud is that some of the specific, simplistic tactics are, in effect, seen as being so unthinkable that most auditors never even take steps to check for their occurrence – in effect, they are “off the radar screen” and thus, paradoxically, more readily available for use by those bent on distorting the entity’s financial results.  For example, inclusion of relatively minor contra-expenses, such as purchases discounts (reductions in acquisition cost from prompt payments to vendors) as sales revenues, which is improper under GAAP, can provide just the desired boost to revenues, to maintain a key period-to-period growth trajectory without misstating gross or net margins, and without being large enough to fall victim to close audit inspection.  Because the proper accounting for purchase discounts (either as contra cost of sales, or as an administrative “other income” item) is presumed to be universally understood, as well as seemingly immaterial, it escapes the attention it deserves.

The internal control and other fraud deterrence and detection solutions to thwart deliberate revenue recognition misstatements will be given consideration in subsequent articles, as will be the auditing procedures – particularly those employing sophisticated analytical analyses – that can be useful in detecting these irregularities when perpetrated by corrupt management.  As the number one family of financial reporting fraud contrivances, these must be given closer and more effective attention if the rate of incidence of fraud is to be reduced, and if auditors are to regain the status in which they should be held by the investing public.

January, 2015

ABOUT THE AUTHOR: Accounting expert Barry Jay Epstein, Ph.D., CPA, CFF, is a Chicago-based forensic accountant, author and frequent expert witness who works with securities attorneys and U.S. regulatory agencies in the areas of white-collar defense, financial reporting, fraud, securities litigation, and auditor liability. He can be reached at barry.epstein@epsteinnach.com.

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