In one sense, there is nothing new when it comes to misstatement of revenue in financial statements. With a little effort, you can find real-life examples of these schemes in both publicly traded companies and privately held companies. How the scheme is perpetrated may differ by industry or by company. How the scheme is concealed may differ by industry or by company. So, how can auditors uncover these schemes?
In my opinion, the answer to the question is simple. The auditor needs to obtain a “deeper understanding” of potential fraud schemes in their audit planning and execution
Internet Search
As I do so often, a simple internet search provides me with the most common revenue reporting fraud schemes, which include:
Fictitious Revenue/Phantom Sales: Recording sales that never happened, often by creating fake customers or backdating invoices/orders.
Early/Improper Revenue Recognition: Recognizing revenue before goods are delivered, shipped (even to third-party warehouses), or before contracts are finalized, as seen in "bill-and-hold" schemes.
Consignment/Bill-and-Hold: Recording sales for inventory shipped to a customer or warehouse but still under the seller's control or with a right of return
Round-Tripping: Arranging with another company to buy and sell the same goods to inflate each other's revenue figures without any real economic activity
Timing Differences: Shifting revenue from future periods into the current period.
Without a “deeper understanding,” the likelihood of your audit being improperly planned to detect intentional and concealed efforts to misstate the financial statements increases dramatically.
By way of demonstrating how to gain a deeper understanding, let’s look at that last one – Timing Differences, and in particular, one form known as channel stuffing, an abstract technique.
For starters, let’s recognize that according to Generally Accepted Accounting Principles (GAAP), revenue is not recognized until it has been earned.
However, there are many ways management can misstate revenue recognition by shifting revenue to a period before the revenue is earned. Believe it or not, there are published cases in which management intentionally either understated or overstated revenue using this method. This is why in our previous blog, we discussed the necessary elements of a fraud risk statement.
In a channel stuffing scheme, management pushes excess product into the distribution channel near the end of a reporting period with the intent to accelerate revenue. This can be done by pushing through extra units through the distribution channel. Or, orders are obtained by offering unusually favorable terms such as extended payment plans or deep discounts, which calls into question whether the transaction represents a true sale. In other cases, management offers informal or undisclosed terms such as the right to return unsold inventory. In each scenario, the substance of the transaction may not support revenue recognition under GAAP, even though it appears valid on the surface.
Develop Your Audit Plan
Now we will discuss how to plan and execute your audit to properly respond to the risk of fraud. In my way of thinking our audit plan has three components.
1. Perform a fraud risk assessment
2. Select a sample of transactions through the use of data analytics
3. Perform an audit procedure to gather evidence regarding the likelihood of revenue being shifted to either an earlier period or a later period.
Fraud Risk Assessment
In this phase, you are identifying the fraud risk statements, and you need to understand the various permutations. Then, based on your fraud risk factors, identify which fraud risk statements should be incorporated into your audit program. With that said, remember my slogan: there is a huge difference between documenting a fraud risk statement and understanding how the fraud risk statement can occur within your audit. Just remember to address the following:
- Direction of Misstatement: In financial reporting, the misstatement could be an overstatement of an account balance or an understatement of an account balance.
- General ledger account: The general ledger account containing the fraud risk statement.
- Where the transaction is recorded: the fraudulent transaction is recorded in a source journal or a general journal.
- Is the transaction based on a false transaction or a real transaction? A false entity or a real entity?
- GAAP Consideration: Remember, fraud in a financial statement is an intentional error in GAAP. Whether the error is based on the fundamentals of GAAP, a specific FASB, or international IFRS.
Management offers oral terms to return unsold inventory within six months of sale, thereby violating the revenue recognition principle (Revenue is earned when you've substantially completed your part of the deal, transferring control of goods or services to the customer), therefore overstating revenue.
Select a Sample
I selected this example because I would argue that it would be very difficult to detect, considering the date when most audit opinions are offered. Furthermore, if the customer does not return the inventory, there will be no overt red flag of the scheme.
Now, because channel stuffing typically occurs in the last month of the year, data analytics by customer, by region, and by territory would reveal a spike in sales by the applicable unit of measurement. Remember, in this risk statement, since no preferential terms are being offered, except the right of return, there would be no traditional red flag to alert the auditor to the scheme.
Perform an audit procedure
Let's think about the traditional audit procedure for testing revenue recognition. Is there a customer order? The answer is yes. Is there proof of delivery? Again, yes, there are shipping documents. Has the realization principle been met? Yes, the customer paid the amount.
Most likely, the customer payment will exceed normal payment terms, because the customer most likely will not pay for the excess inventory until the customer has sold the inventory. Therefore, our best bet to detect the scheme is to search for returns or delayed payments in the following year. Unfortunately, both of these audit procedures can only be performed after the audit opinion is offered.
Fraud Trivia
This month: more on Donald Cressey
- Donald R. Cressey can be considered the founder of the modern study of organized crime. True or False?
- Dr. Donald R. Cressey is considered one of the nation's leading experts on the sociology of crime. True or False?
- Donald Cressey served in the Army Air Forces during World War II. True or false?
- Donald Cressey PhD thesis was titled ____?
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What criminologist was Cressey's mentor?
Last month's answers:
- Who is credited with coining the phrase “Fraud Triangle”? W. Steve Albrecht
- How many convicted embezzlers did Dr. Cressey interview for his work? 133
- True or False: Were habitual criminals excluded from the study? True
- How many prisons did Dr. Cressy visit to conduct his interviews? Three
- True or False: The origins of the fraud triangle were from Dr. Cressey's PhD Thesis? Somewhat true.
