Long before WorldCom and Enron, managers were inflating and deflating the numbers to increase stock prices, earn fat bonuses, comply with loan covenants, cover up asset misappropriations, and fund personal expenses, among other motives.
"Bud," the controller of a large company, "Bacme Inc.," knew the financial picture looked dismal.1 But rather than admitting business was declining, he decided to "pretty up" the income statement. Prior to the auditors' arrival he inflated accounts receivable and revenue. The ruse worked so well, he tried it again the next year, and the year after.
Intentional misstatement of revenues became the fashionable fraud in 2002. But the crime existed long before WorldCom and Enron. In 1999 alone, more than half of the Security and Exchange Commission's (SEC) fraud cases involved falsifying revenue.
As stocks fizzle, Wall Street presses firms to keep earnings and share prices high. Also, stock options and bonus packages are pegged to company performance. After the SEC issued its Staff Accounting Bulletin No. 101 of Dec. 3, 1999, on revenue recognition, 32 companies changed accounting policies or restated revenue.
Auditors and fraud examiners need to know the revenue inflation (and deflation) red flags and learn the lessons from the well-known and obscure cases.
Let's revisit Bud and his efforts to pump up the numbers. In the early audits, he could easily conceal his misdeeds. Bacme's audit firm usually sent in junior auditors to confirm and audit accounts receivable.
Bud would make excuses for not confirming certain balances: a customer was located out of the country and it would take too long for a response, or the company's accounting department was a mess and it would not be able to provide an accurate response. Bud would then convince the auditor to review invoices and shipping documents that he had fabricated. He would also encourage the auditors to call customers on the phone in lieu of sending written confirmations of sales. He would dial the number of an alleged vendor and hand the phone to the auditor. The auditor would document whom he talked to and the response. The auditor would not realize that Bud was actually talking to an accomplice either down the hall or across the street at a pay phone. When the auditors did send sales confirmation forms to vendors they would unwittingly mail them to post office boxes set up by Bud the controller. He would collect the confirmations, forge signatures, and return them with the "no exception" box checked (which indicates that the respondent agreed with the information).