Revenue-Related Financial
Statement Fraud
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Revenue and Financial Statement Restatements
 Revenue is the biggest reason that financial statements are
restated
Restatements by Reason (June 1997 - 2002)
IPR&D
Reclassification 4%
5%
Related-party
transactions
3%
Revenue
38%
Securities-related
5%
Acquisition/merger
6%
Restructuring/
assets/ inventory
9%
Other
14%
Cost/Expense
16%
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Why Revenue-Related Financial
Statement Frauds Are So Prevalent
 There are many alternatively accepted revenue recognition
procedures and many situation-specific ways to interpret
and apply each of these procedures
 It is easy to manipulate net income using revenue and
receivable accounts.
 A common revenue problem occurs when organizations
stuff their distribution channels ahead of demand,
prematurely recognizing revenue.
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 COSO-sponsored study found that over half of all
financial statement frauds involved revenues and/or
accounts receivable accounts.
 The COSO study also found that recording fictitious
revenues was the most common way to manipulate
revenue accounts, and that recording revenues
prematurely was the second most common type of
revenue-related financial statement fraud.
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A study by the Deloitte Forensic Center that reviewed SEC
enforcement releases from 2000 to 2008 found that revenue
recognition was the most common financial statement fraud
scheme. The study also found that company officers were named in
81% of the enforcement releases and that the six most common
revenue recognition fraud schemes include:
 Recording of fictitious revenue.
 Recognition of revenue when products and services were not
delivered.
 Recognizing inappropriate amounts of revenue from swaps,
bartering or other types of arrangements.
 Recognition of revenue where there were contingencies
associated with the transactions that had not yet been resolved.
 Recognition of revenue from sales that were billed, but not yet
shipped (‘bill and hold' schemes).
 Recognition of revenue in an inappropriate period.
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There are also various other ways that revenues
can be used to falsify financial statements:
 Revenues can be recognized earlier than they should in cases of
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long-term construction-type contracts where revenues
recognized depend upon the percentage of completion of a
project.
Revenues can be improperly recognized from sales transactions
billed without shipping the goods (bill and hold).
Revenue can be created through adding fictitious
documentation, sales, or customers to make it appear that actual
sales were higher than they were for the period.
Contracts upon which revenue recognition is based can be
altered or forged.
Topside journal entries, without underlying documentation, can
be used to create fictitious revenues and receivables.
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Identifying Revenue-Related Exposures
 One of the easiest ways to understand how revenue-
related financial statement frauds can be perpetrated is to
first focus on the various kinds of revenue transactions
that exist. And, one of the easiest ways to understand
revenue-related transactions is to diagram the various
interactions between an organization and its customers,
analyzing the accounts that are involved in each
transaction, and trying to determine how misstatement
could occur with each transaction.
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Revenue-Related Transactions
1. Sale Goods and/or Services
2. Estimate Uncollectible Accounts Receivable
3. Accept Returned Goods
Yes
Goods
Returned?
No
Receivable
Paid?
No
4. Write-off Receivable
Yes
Discount
Taken?
No
5. Collect Cash
Yes
6. Collect Cash Minus Discount
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Matrix for Identifying Revenue-Related
Fraud Transactions
Transaction
1. Sell goods
and/or
services to
customers
Accounts Involved
Accounts receivable, 1.
revenues (e.g.,
sales revenue)
2.
3.
2. Estimate
uncollectible
accounts
receivable
3. Accept
returned
goods from
customers
4. Write-off
receivables as
uncollectible
Bad debt expense,
allowance for
doubtful accounts
4.
Sales returns,
accounts receivable
5.
5. Collect cash
after discount
period
Cash, accounts
receivable
6. Collect cash
within discount
period
Cash, sales
discounts, accounts
receivable
Allowance for
doubtful accounts,
accounts receivable
Fraud Schemes
Record fictitious sales (related
parties, sham sales, sales with
conditions, consignment sales, etc.)
Recognize revenues too early
(improper cutoff, percentage of
completion, etc.)
Overstate real sales (alter
contracts, inflate amounts, etc.)
Understate allowance for doubtful
accounts, thus overstating
receivables
Not record returned goods from
customers
6. Record returned goods after the
end of the period
7. Not write-off uncollectible
receivables
8. Write-off uncollectible receivables
in a later period
9. Record bank transfers as cash
received from customers
10. Manipulate cash received from
related parties
11. Not recognize discounts given to
customers
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Identifying Revenue-Related
Fraud Symptoms
 Analytical Symptoms: These involve things that are unusual –
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too big, too small, wrong time, wrong person, and so on
Accounting or Documentary Symptoms: These involve
discrepancies in the records
Lifestyle Symptoms: Fraud perpetrators often improve their
lifestyles, especially in small companies
Control Symptoms: Breakdowns in the control environment
Behavioral and Verbal Symptoms: Fraud perpetrators change
their behavior to cope with their stress and guilt
Tips and Complaints: Tips or complaints from employees,
spouses, vendors, customers, and others
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Analytical Symptoms
 Reported "revenue or sales" account balances that appear too
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high.
Reported "sales discounts" account balances that appear too low.
Reported "sales returns" account balances that appear too low.
Reported "bad debt expense" account balances that appear too
low.
Reported "accounts receivable" account balances that appear too
high.
An unusual increase in "accounts receivable."
Reported "allowance for doubtful accounts" account balances
that appear too low.
Too little cash collected from the revenues that are being
reported.
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Accounting or Documentary Symptoms
Revenue-related transactions not recorded in a complete or timely manner or
improperly recorded as to amount, accounting period, classification, or entity
policy.
 1.Unsupported or unauthorized revenue-related balances or transactions.
 2.Last minute revenue adjustments by the entity that significantly
improves financial results.
 3.Missing documents in the revenue cycle.
 4.Unavailability of other than photocopied documents to support revenue
transactions when documents in original form are supposed to exist.
 5.Significant unexplained items on bank and other reconciliations.
 6.Revenue-related ledgers (sales, cash receipts, etc.) that do not balance.
 7.Unusual discrepancies between the entity's revenue-related records and
corroborating evidence (such as accounts receivable confirmation replies).
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 Control Symptoms
 Management override of significant internal control
activities related to the revenue cycle.
 New, unusual, or large customers that appear not to
have gone through the customer-approval process.
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Behavioral or Verbal Symptoms
 Inconsistent, vague, or implausible responses from management
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or employees arising from revenue inquiries or analytical
procedures.
Denied access to facilities, employees, records, customers,
vendors, or others from whom revenue-related audit evidence
might be sought.
Undue time pressures imposed by management to resolve
contentious or complex revenue-related issues.
Unusual delays by the entity in providing revenue-related,
requested information.
Untrue responses by management to queries made by auditors.
Suspicious behavior or responses from members of management
when asked about revenue-related transactions or accounts.
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Actively Searching for Revenue-Related “Analytical”
Symptoms Focusing on Changes in Recorded Amounts
From Period to Period
The specific analyses that can be conducted usually include:
 Analyzing financial balances and relationships within financial
statements.
 Comparing financial statement amounts or relationships with other
things.
There are two common ways to perform within-statement analysis:
 Looking for unusual changes in revenue-related account balances
from period to period (looking at trends—horizontal analysis).
 Looking for changes in revenue-related relationships from period to
period.
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 Two primary types of analyses to compare financial
statements with other information:
 Comparing financial results and trends of the company
you are analyzing with those of similar firms in the same
industry
 Comparing recorded amounts in the financial
statements with assets they are supposed to represent
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Focusing on Changes in Revenue-Related
Relationships
 Two primary ways to examine changes in relationships
from period to period:
 Focus on changes in various revenue-related ratios from
period to period
 Convert financial statements to common-size
statements (converting balance sheet and income
statement numbers to percentages—vertical analysis)
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Most Commonly Used Ratios
 Gross Profit (Margin) Ratio
 Sales Return Percentage
 Sales Discount Percentage
 Accounts Receivable Turnover
 Number of Days in Receivables
 Allowance for Uncollectible accounts as a Percentage of
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Receivables
Asset Turnover
Working Capital Turnover
Operating Performance Ratio
Earnings Per Share
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Actively Searching for “Accounting and
Documentary” Symptoms
 In the past, the major way to search for accounting and
documentary symptoms was to take samples from
populations of documents and make inferences about
the population
 Now we use data query programs and languages (such
as Audit Command Language – ACL) to data mine
entire databases very quickly
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Fictitious Revenues
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Customers not approved
Invoices out of sequence
Duplicate sales invoices
Sales invoices without corresponding shipping invoices
Sales volume by customer
Patterns of sales (e.g., immediately prior to period end)
Large amounts of sales returns
Lack of taking sales discounts
Sales invoices without bills sent to customers
Missing sales invoices
Excessive voids or credits
Several customers with the same name
Several customers with the same address
Increased past due accounts receivable
Ledgers that do not balance
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Recognizing Revenues Too Early
 Volume of sales immediately before and after year-end
 Sales returns and sales discounts of year-end sales
compared with other sales periods
 Matching of sales invoice dates with shipping dates
 Large “topside” journal entries made after the financial
statements have been prepared
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Actively Searching for
“Control” Symptoms
 Fraud examiners and investigators usually consider a
control breakdown not only as something that must be
fixed “for the future,” but something that must be
examined to see if it has been abused in the past
 It is often the control environment, rather than
specific control activities or procedures, that is weak
and must be examined
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Actively Searching for “Behavioral or
Verbal” and “Lifestyle” Symptoms
 If there is one fraud detection tool that is under-used by
auditors and others, it is making verbal inquiries and
personal observations
 Lifestyle symptoms are much more common in employee
fraud than financial statement frauds because most
financial statement frauds usually do not benefit the
perpetrators directly
 Liberal communication with a manager who is
committing financial statement fraud will often reveal
inconsistencies in responses that can help you
understand that everything is not the way it is being
represented toCopyright
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Actively Searching for “Tips and
Complaints” Symptoms
 The best way to search for tips and complaints is to institute an
ombudsman, hotline, or toll-free phone number that people can
contact or call with tips
 In most organizations, there are individuals who have knowledge
that fraud is occurring but are afraid to come forward because
 They do not know who to tell or how to come forward
 They do not want to wrongly accuse someone
 They are afraid of “whistleblower” repercussions
 They usually have only suspicions rather than actual knowledge
 Auditors should have significant communication between
themselves and client personnel; you get few tips or complaints, or
both, if you do not talk to people
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Following Up on
Symptoms Observed
 Auditor
 Exercise Higher Levels of Skepticism
 Assign Higher Skilled and More Knowledgeable Personnel to the
Engagement
 May Need to Further Consider Management’s Selection and
Application of Significant Accounting Policies
 May Need to Assess Control Risk below the Maximum
 May Need to Change Nature, Timing, and Extent of Tests
 Investigator
 Theft-Act Evidence
 Concealment Evidence
 Conversion Evidence
 Interviews & Interrogation
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