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Charles Lundelius
Charles Lundelius, Jr.

Battling Fraud

How to recognize fictitious revenues.

October 06, 2011
by Charles Lundelius, Jr., CPA, ABV

In 1999, the Committee of Sponsoring Organizations (COSO) sponsored research published under the title Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies (the 1999 research report), which found that one-half of the financial reporting frauds in the period 1987-97 were attributable to overstating revenue. In 2010, COSO’s subsequent study of the 1988-2007 period, titled Fraudulent Financial Reporting: 1998-2007, An Analysis of U.S. Public Companies (the 2010 research report) found that revenue recognition fraud had increased to 61 percent. Of those companies overstating revenue, both the 1999 and 2010 research reports found that recording fictitious revenues and recording revenues prematurely were the primary sources of fraud.

Persuasive Evidence

Because of pressures and possible misrepresentations, the U.S. Securities and Exchange Commission (SEC) standard [SAB 104] requires persuasive evidence, which generally means some written documentation from either the buyer or a third party, such as a purchasing agent. For example, assume that Selling Company’s salesperson has obtained verbal approval from Customer Company’s management about the terms of a sale. Further, assume that Customer Company’s management must obtain approval of the sale’s terms from Customer Company’s legal department, and the agreement is held up at the end of the quarter due to legal department review. Without a requirement for written documentation of the sale, Selling Company’s salesperson may represent (perhaps accurately) that Customer Company’s purchasing decision maker has signed off on the sale but misrepresent that all conditions for revenue recognition are met. However, with the requirement for a signed contract, recognition of the sale would not occur at quarter-end and for good reason: Customer Company has not agreed to the terms until the legal department review is complete. Such a policy is put in place to ensure the company conforms to U.S. generally accepted accounting principles (U.S. GAAP). Violating that policy causes a violation of U.S. GAAP if, in the footnotes to the financial statements or elsewhere, management represents that sales are not recognized without a written agreement.

Actually, the SEC looked beyond company policies in SAB No. 104. A hypothetical posed in the bulletin stated the normal and customary business practice was to obtain written agreements and did not mention the existence of a company policy to obtain written agreements. The staff ’s position was that companies could not book sales lacking written agreements as revenue, regardless of company accounting policies, when the normal and customary business practice for the industry was to obtain written agreements.

Detecting Fake Agreements

Good sales cutoff procedures can generally detect lack of proper agreements, but if written agreements are fabricated, detection is much more difficult. Random sampling of orders booked as revenue near the end of a quarter should provide a list of customers to call to verify that documents are authentic. However, for a document fabrication scheme to succeed over several quarters or years, the fabricated agreements must be replaced by authentic agreements and real sales or there will be significant reversals of prior period sales.

Therefore, CPAs can compare, perhaps on a random basis, contracts on file at the end of a given reporting period with contracts on file for the same transaction at a later period of time. If the original (fake) contract has been switched, there probably was an attempt at fabrication. Conversely, if the authentic document does not appear, the sale may never have been completed, in which case there would be a reversal in the subsequent period. Numerous instances of such reversals would point to internal control problems.

Nondelivery

What constitutes delivery varies from industry to industry but generally occurs when title and risk of loss pass to the buyer. Delivery of some products requires shipping documents that provide a paper trail that can be audited. Delivery of products such as software may occur over the Internet at near instantaneous speed with lagging paper documentation or none at all. Nevertheless, there should be some follow-up hard copy documentation or electronic receipt verification.

Attempts at achieving fraudulent deliveries usually involve some person or entity willing to hold the product until such time as its sale can be arranged. As part of the fraud scheme, the recipient executes documents or e-mails that appear to confirm delivery to an entity that appears to be the ultimate customer. This recipient is sometimes part of the scheme or can be a customer who inadvertently accepts delivery before consummating the sale. The inadvertent error may be easier to detect because customers receiving products before they are wanted tend to complain to company management.

Third-party recipients who park goods temporarily may be harder to detect but usually require some payment for their services. Payment may come in the form of above-average discounts if the third parties resell the products over future periods, or there may be special terms allowing for product returns. An analysis of average product selling prices may point to one customer who stands out from the rest by receiving better deals.

If returns from a given customer are abnormally high, that fact may also indicate special arrangements, especially if the returns occur in a later reporting period. If one customer receives such favorable treatment, the CPA should make additional inquiries. In addition, delivery schemes involving resellers typically become more apparent if other resellers cannot sell the product as expected because of a change in market conditions. If a reseller is still taking substantial deliveries of a product after many others are experiencing sales declines, the CPA should attempt to understand why that reseller’s channels of distribution are clear but others are blocked.

No Fixed Price

A price may not be fixed due to design or deceit. A price not fixed due to design may arise from a sales price being a function of royalty percentages, sliding scales, or other features that depend on future events before the price becomes fixed and determinable. A price not fixed by deceit usually consists of hidden agreements that allow the buyer to pay less than the stated, presumably fixed, sales price.

This article has been excerpted from Financial Reporting Fraud: A Practical Guide to Detection and Internal Control. This publication is available on CPA2Biz.



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Charles R. Lundelius, Jr., CPA, ABV, CFF, has worked in forensic accounting for 20 years. He assisted in the investigation of the failure of the SEC to uncover Bernard Madoff’s Ponzi scheme.